Those who work in the financial markets might be led to believe that a curse hangs over the third and fourth quarters of years ending with the number 7. In mid-August 1987, stock markets peaked, up 30% year-to-date. Two months later, Black Monday arrived without warning.
In July 1997, Thailand, crushed by a mountain of debt and unable to acquire enough hard currency to defend the baht's peg to the US dollar, was forced to let the exchange rate float. The baht crashed, driving the country into bankruptcy and infecting much of Southeast Asia. Thailand and the Philippines asked the IMF for help, and in the autumn Indonesia and South Korea were forced to do the same. In October, panic had hit developed markets.
On August 6, 2007, the combined effects of overcrowded positions, leverage and complacency caused increased pressures on some quantitative investment portfolios. Those pressures exploded in a "quant quake" that shook stock markets for a week, leaving its mark on quantitative and value investors, who took years to recover.
Three days later, in one of the moments that marked the credit crisis, the interbank money markets suffered an unprecedented crisis when BNP Paribas was forced to suspend the repayments of three ABS funds deemed "safe" until then. Within a month, customers of a major British retail bank found themselves queuing at counters trying to clear their account.
Volatility can strike without warning
The convergence of these anniversaries may cause investors to wonder about the nature of volatility and market risk, while the sudden resurgence of volatility late last week in response to the skirmishes between North Korea and the US may cause us to wonder on such anniversaries. What stands out is the ability of financial markets to ignore tensions and stressful situations for a long time and then discount them all at once.
Black Monday and the quant quake occurred without any clear warning signs. The subprime mortgage crisis and the credit crunch were clearly foreseeable, for anyone who wanted to catch the signs: already in February 2007 Freddie Mac had stopped buying subprime mortgages, in April New Century Financial had declared bankruptcy and in June (two months before of BNP Paribas) Bear Stearns had suspended the redemptions of the ABS funds.
Nonetheless, the S&P 500 index closed the month of July 2007 up 7,5% from the beginning of the year. Even after wobbling in
August and November closed the year up 4,4%. Few predicted that a five-year bull market had just peaked and that one of the most devastating crashes in financial history was about to unfold.
It's hard to predict the future
Should last week's exchange of statements escalate into a more serious situation, historians will point out that investors once again failed to predict it. Even as the verbal battle became heavy in the first half of last week and Asian markets started to shake, the S&P 500 continued to rise, setting a new market session record with no change of more than 0,3%. It was necessary to wait until Thursday for the situation to finally be understood.
But only those who have the gift of retrospection and have not bet anything on risky instruments would blame investors for these oversights. The recent volatility seems justified. The human and economic cost of any firefight between North Korea and the United States or its allies, and the proximity of the crisis to an important economic and geopolitical player such as China, imply that even the slightest probability of such a development could be sufficient to generate a financial risk. At the same time, it is very likely that everything will end in nothing. In that case, we'd be back to corporate balance sheets and fundamentals, reveling in the upbeat aura of two strong earnings seasons.
Anyone who positioned themselves to deal with a subprime mortgage crisis in 2005 or 2006, only to have their customers walk away to cushion grievous losses, can attest to not only how important positioning is for market volatility, but also how easy it is for investors ignore signs of strain, favor one data set over another, or get carried away by the stories of individual companies or trends.
We believe the best lesson to be learned from the events of 1987, 1997 and 2007 is to let go of complacency and overconfidence in one's ability to predict the events of the coming week, month or year. Conversely, our experience in those three momentous meltdowns tells us that an adequately diversified portfolio is the one most likely to survive 2027, 2037 and 2047 unscathed.
