May 11, 2010
Given the ratio's predictive powers, government regulators may be able to use the absorption ratio to help head off global financial crises. In a study of daily stock market returns for 42 countries, Kritzman found that the absorption ratio spiked just before nearly every major market panic of the past two decades, including in October 1997, during Hong Kong's speculative attack after the Asian Financial Crisis; in August 1998, in parallel with the onset of the Russian financial crisis and the collapse of the Long-Term Capital Management hedge fund; and in mid-2006, coinciding with the national drop in housing prices and in anticipation of the collapse of Lehman Brothers. Conversely, the ratio declined leading up to global market expansions. It dropped preceding the recovery in emerging markets in 1999-2001, as well as before the boom that followed severe drops in interest rates in 2001. The graph below shows the trajectory of the global absorption ratio from January 1997 to January 2008, with labels to denote the timing of major financial crises.
Source: Mark Kritzman
In the end, however, the same caveats that apply to other financial forecasting and trading formulas will likely apply to the absorption ratio as well. Even if Kritzman's formula does fit well with the statistical record of the past two decades, new conditions could emerge that make the ratio stop working as a reliable predictor of market performance. As Kritzman notes, while the absorption ratio does show noticeable spikes immediately preceding financial crises, it has also undergone a long-term upward trend (from 65 percent in February 1995 to 85 percent by December 2009). Considering the rapid pace of liberalization and deregulation in global markets over the past two decades, this is not surprising. The problem, however, is that the absorption ratio only measures susceptibility to the spread of shocks, not the causes of shocks themselves. If the upward trend in the absorption ratio continues, this could erode the statistical difference between times when markets actually are in serious peril and times when threats to markets are relatively few.
Another pitfall of the absorption ratio is its potential to alter investor behavior if it is ever put to widespread use as a market timing mechanism. Shifts in the ratio could become self-fulfilling prophecies. A sudden spike in the ratio could prompt investors to stampede out of the stock market and into bonds, thus contributing to the very market fragility the model purports to predict. Alternatively, a sudden drop in the ratio could fuel a rapid influx of capital into stocks, driving up prices and artificially inflating the market's apparent strength. If this happens, the brief time windows between shifts in the absorption ratio and shifts in asset values that allow followers of the model to reap profits in the stock and bond markets could eventually dwindle down to zero.
Kritzman first released his work on the absorption ratio in a report for the Revere Street Working Paper Series in March. The paper was coauthored by Roberto Rigobon, as well as Yuanzhen Li of Windham Capital Management and Sebastien Page of State Street Associates. Kritzman presented his findings at a meeting of the Quantitative Work Alliance for Applied Finance, Education and Wisdom on April 20 in Boston.
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