Equity markets could be a “small trigger” away from crashing down from current near-high levels, a note from Citigroup has warned today.
Researchers argued that the world is currently not an uncertain place, but that with certainty comes complacency, “and with complacency comes risk”.
They said that in this environment, “traditional measures of market volatility are a poor indicator of sentiment change”.
We see signs in the recent price action that there may be complacency developing, and with this we think the chances of a risk reversal may be rising.
Citi said investors need to worry about “unexpected outcomes to expected events” rather than “black swan” events.
“These outcomes catch market participants by surprise because of an embedded bias or because of cognitive dissonance; behaviours that lead to excessive or congested positioning around a widely expected outcome,” the note said.
“It is this type of surprise that tends to trigger the risk reversals that lead to the largest and most enduring moves.”
It said this is not reflected in market volatility, but spikiness in markets and greater kurtosis, a statistical measure of distribution of observed data around the mean, described by Investopedia as “the volatility of volatility”.
Citi said we should be looking at the “shape of the distribution of the price action in markets” rather than volatility to try and predict changes in risk appetite.
It used this graph:
It is worth considering that the spike in November 2015 peaked just as the equity markets turned, leading to a 15 per cent reversal in global stock markets that lasted for three months.
We are not suggesting that a similar move is imminent, but we would caution that recent price action suggests that confidence might be waning. A big reversal will still require a trigger, but it might only need to be a small trigger. Beware of unexpected outcomes to expected events.