Authored by Francesco Filia via Fasanara Capital,

The Increasing Frequency of VAR-shocks is a Crash Hallmark

Systemic Risk as a Complexity Problem

We can never predict the exact point at which the system transforms.

We live in a stochastic world and the final little push out of equilibrium may happen randomly.

But what we can say is when the system has become inherently unstable, fragile, vulnerable,ready for small perturbations to trigger critical transitions, in phase transition zone.

If we have reasons to suspect the possibility of a critical transition, the analysis of generic early warning signals may be a significant step forward when it comes to judging whether the probability of a transition is increasing.

It is hard to be bearish in a bull market, expecting a major sell-off to strike at any moment throughout blue-sky markets. Oftentimes, markets rebound from lows and critical technical levels such as 200 days moving averages, death crosses and flash crashes – in spite of bad fundamentals or blunt evidence of trouble ahead. However, this is no surprise, and actually is typical of other infamous market crashes over the course of financial history. Without exceptions, the worst declines described in the history books were preceded by lower than average volatility, stronger than average earnings momentum, good GDP growth, bullish sentiment and multiple vicious rebounds after early timid declines. Bull traps were visible on the pathways of 1929, 1987, 2000 and 2007, most notably.

The signposts of a potential market crash are coming in with increasing hubris. The increasing frequency of VAR-shocks is one such indicator, which comes in confirmation of our broader market assessment of systemic fragility for global markets.

A few recent case studies stand out, where investors all of a sudden wanted out of a market like people fleeing from a burning building:

• We saw the volatility index VIX ballooning from 9 to 50 in the span of two weeks, while ETP instruments like the XIV were wiped out: more VIX futures contracts were traded in a single day (a quarter of an hour, really) than ever before in history, eclipsing the previous record by a factor of 4. The largest move ever, and an 6 standard deviations move.