Rethinking Risk

Market Valuations and Bubble Concerns

• The U.S. market capitalization-to-GDP ratio is 125%, approaching the 136% peak seen in March 2000.
• Global market capitalization has risen 190% since March 2009, while global GDP grew only 23% in the same period.
• David Solomon argues that broad equity markets are not currently in "bubblish territory," noting that bubbles are inherently difficult to identify before they burst.
• Solomon identifies negative interest rates and ultra-accommodative monetary policy as key drivers distorting risk management and market structures.
• Approximately 30% of global sovereign bonds are trading with negative interest rates, creating significant pressure on underfunded pensions and vulnerable insurers.

Corporate Leverage and Monetary Policy Consequences

• U.S. corporations have added a net $2.5 trillion in outstanding debt since 2009 despite generating over $500 billion in net free cash flow.
• Corporate capital allocation has skewed heavily toward capital returns, with 90% of earnings directed to buybacks and dividends in 2014 and 2015.
• Vlad Portnoy warns that monetary policy is forcing investors to reach for yield and extend duration, creating vulnerability to future interest rate normalization.
• Historians note that the 1994–2005 interest rate hike cycle caught markets by surprise, leading to significant volatility and market pain.
• Jane Buchan cautions that central banks are "playing the long game" to extend the current credit cycle, which may delay necessary downturns and increase future instability.

Systemic Risk and Regulatory Frameworks

• Five of the eight largest banks failed the Federal Reserve and FDIC's "credible living will" submissions; two banks (Goldman Sachs and Morgan Stanley) received conflicting assessments of credibility between the regulators.
• Myron Scholes contends that current macro models rely on historical data from "normal times," failing to account for tail risks and changing correlations during crises.
• Scholes argues that option markets, which offer forward-looking risk distributions and price insurance on assets, provide superior data for modeling tail correlations compared to backward-looking regulatory stress tests.
• Regulators are criticized for ignoring "beta risk" (systemic risk) in favor of microprudential rules that focus on individual bank health.
• Scholes asserts that the leverage markets and option prices in 2008 and 1987 clearly signaled impending crises, information that regulators failed to utilize.

Liquidity Risks and Market Structure Changes

• Basel regulations and a shift in market microstructure have reduced liquidity provided by broker-dealers, removing traditional "shock absorbers" from the system.
• Many investment managers now utilize stop-loss mechanisms that assume liquidity will exist during market dislocations, potentially exacerbating sell-offs if that liquidity disappears.
• Pension funds with negative pay ratios and low cash reserves face structural pressure to sell assets for benefit payments regardless of market conditions.
• Jane Buchan predicts that if large pools of capital attempt to liquidate simultaneously using stop-loss triggers, the market making system may fail to absorb the orders, leading to disasters.
• The SEC is revising liquidity management and derivative exposure rules for mutual funds and ETFs, moving away from rigid capital requirements toward disclosure and categorization.
• Buchan argues against designating mega-funds as Global Systemically Important Financial Institutions (G-SIFIs), noting that funds do not act as monetary policy transmission mechanisms.

Portfolio Construction and Risk Management Philosophy

• Myron Scholes emphasizes that investors should prioritize "time series diversification" (managing risk over time) over "cross-sectional diversification" (holding many assets), as volatility erodes compound terminal wealth.
• Investing in index funds without active risk management is described as ineffective because the risk profile of benchmarks like the S&P 500 changes dramatically over time.
• Vlad Portnoy warns that while modern portfolio construction tools are more sophisticated, the widespread use of identical models by different managers creates correlated behavior that can amplify crashes.
• Jane Buchan notes that stress-testing models exclusively against the 2008 crisis is flawed, as future crises will manifest differently due to changed market behaviors and regulations.
• David Solomon advises asset managers to be disciplined and avoid taking excessive risk to meet liabilities, anticipating that central bank support for risk-taking will eventually end.
• Panelists agree that relying on Value-at-Risk (VaR) models based on historical volatility is insufficient for predicting tail events, as correlations often break down during systemic shocks.