Value At Risk Raising Risk

 I just read a very insightful article on the effects that Value At Risk (VAR) portfolio models and regulations may have on markets.  In sum, VAR could force portfolio managers and banks to sell into a down market to reduce exposure, thus accelerating and deepening the move.  The author draws a parallel to the 1987 "portfolio insurance" debacle.

In the past, investment portfolios containing both stocks and bonds were somewhat protected from such a possibility, since equities and bonds were negatively correlated: when stocks went down bonds moved up thus keeping VAR pretty steady. For the past 30 days,however, the correlation has turned positive and stocks are coming down along with bonds - Chart 1.

Chart 1 - SP500 and 10 Year Treasury Futures Moving Down Together 

The common thread between stocks and bonds is market risk.  While stocks have always been risky, Treasury bonds were considered a safe haven.  But, given the enormous bond supply hitting the market, very low interest rates and the Fed's continuing apathy towards inflation, bonds are now risky, too, so they are also coming down as risk appetite subsides.

In other words, you can certainly run (get out of stocks and bonds), but you can only hide in cash which pays you zero, or less (if you are in Euro).  Now, portfolio managers have a violent dislike of cash since they don't get paid to sit on it - and why should they?  But here's the rub: it's almost always the case that the asset class that outperforms over the next 12 months (or 24, 36. 48...) is the one that has had the worst performance in the past.  Naturally, cash has been in the doghouse for ages...