The Risk Of A Crash Has Never Been Higher?

According to the CBOE SKEW Index, the risk of a stock market crash has never been higher.

What exactly does that mean?

The SKEW Index is calculated based on S&P 500 options, measuring the perceived tail risk in S&P 500 returns over the next 30 days. The higher the SKEW Index, the higher the implied probability of a left tail or black swan event (click here for a white paper explaining the calculations in detail). At a level of 154, the implied risk of a 2 or 3 standard deviation negative event is higher than it has ever been.

Source: CBOE

That all sounds incredibly scary, and many a clickbait article would end right here. But as you know by now, I don’t do clickbait very well. We’re here to learn, and learning requires objective analysis.

The key question is not whether perceived tail risk is high (it appears to be), but whether high perceived tail risk tends to translate into high actual tail risk. To answer that question we need to go to the data.

The SKEW Index dates back to January 1990. If we look at the top 5% of values historically (above 131), what does SKEW tell us about forward returns?

In a word: nothing. On average, the forward S&P 500 returns are not materially different from any random SKEW value.

 

What’s most interesting, though, is that the SKEW Index has been a very poor predictor of what it’s supposedly anticipating: actual tail risk. To observe that we can compare the worst stock market declines following the highest SKEW levels to the lowest SKEW levels.

As can see in the table below, in every period from 1 day through 12 months, the worst declines following high SKEW levels are actually much lower than the worst declines following low SKEW levels.

 

Another way to observe the lack of tail risk predictability in SKEW is to look at the largest 1-day S&P 500 declines. Going back to 1990, none of the worst declines had a SKEW Index in the prior month that was win the top 5% of historical values. So when actual tail risk was present, SKEW did not predict it.

1 2
View single page >> |

Disclaimer: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more consistent defensive alternative to stocks during periods of market stress with lower volatility and drawdowns than Gold. In our research on Treasuries (click here) and Lumber/Gold (click here), we illustrate tactical strategies that use bonds as the default position when equity volatility is expected to rise.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

...more
How did you like this article? Let us know so we can better customize your reading experience. Users' ratings are only visible to themselves.

Comments

Leave a comment to automatically be entered into our contest to win a free iPad Pro.