By: Catherine Yoshimoto, Sr. Index Product Manager
I finally watched The Big Short last night, a comedic portrayal of the bubbly sentiment surrounding the housing sector leading up to the Global Financial Crisis. This got me thinking about what we can extrapolate from these past events to help guide us through the choppy waters of today.
In the movie, a hedge fund manager heads to Miami in search of clues to confirm his suspicion that the housing market is about to collapse. The hilarious cast of characters he meets includes unscrupulous mortgage brokers, a stripper with outstanding loans on five houses and a renter whose landlord is delinquent on a mortgage taken out in his dog’s name. Meanwhile, on Wall Street, there are bankers willing to ignore the market’s glaring anomalies in return for a fee and a quick profit. While laughable, this is a fairly accurate depiction of some of the players and victims of the subsequent collapse of the housing market and some of the largest financial power houses.
But laughter aside, were there warning signs that the mortgage bubble was ballooning and about to burst? Looking at the volatility of the Russell 3000® Index (a measure of US listed stocks) in the chart below, we can see that volatility started to increase prior to the housing bubble burst in 2008, eventually hitting record highs as the bubble popped. After declining for the next few years, the index reached a period of relative stability. However, mid-2015 saw volatility start to creep back up again. This increase in volatility has prompted market pessimists to proclaim the common mantra that “all good things must come to an end.” Is this increase in volatility a possible sign of more rough times ahead? And if so, how can we avoid the unfortunate fate of the comedic characters from the movie?
Russell 3000 Index Volatility
To understand the market dynamics at work, it is helpful to examine how different portions of the Russell 3000 Index are affected, through the lens of the Russell Stability Indexes. Historical data suggests that during periods of market decline, the variation in value of the Russell Defensive Indexes™ has been less pronounced than that of the Russell Dynamic Indexes™, which are typically more sensitive to market volatility. As you can see in the chart below, there has been quite a bit of flip-flopping of performance between the more volatile Russell 3000 Dynamic Indexes and the more stable Russell 3000 Defensive Indexes in 2016. In the first 2 months of the year as the broad market Russell 3000 Index was down, the Defensive Indexes performed higher than the Dynamic Indexes. Then, as the index’s performance turned positive in March, that relationship reversed. It’s interesting to see that on a longer-term basis, the more stable Defensive Indexes have performed higher than the Dynamic Indexes.
Performance of Russell 3000 Style and Stability Indexes over the last 10 years
Reflecting back on the pre-Global Financial Crisis housing bubble, let’s not forget that while there were people with questionable credit histories carrying 5 or more loans at a time on homes they could not afford or even dogs who were delinquent on their mortgages, there were some who remained cautious. Homeowners who took a defensive approach and did not overextend themselves by taking out excessive loans that eventually defaulted were not impacted nearly as badly.
Market participants can use Russell Defensive Indexes as a way to gauge or to create investable products focusing on the less volatile side of the global equity markets by using them as benchmarks or as the basis of investable products. While we must hope that the increase in volatility may not exactly be, in Yogi Berra’s immortal phrase, “déjà vu all over again”, the Russell Defensive and Dynamic Indexes do provide index tools that help market participants better differentiate these market ups and downs.
 To learn more about the Russell Stability (Defensive and Dynamic) Indexes, please see: http://www.ftse.com/products/indices/Russell-Stability
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