'Risk' May Be Low But Uncertainty Over "Unknown Unknowns" Just Hit Record Highs

While the fear-tracking VIX has been languishing near record lows this year, a gauge of so-called ambiguity, meant to chronicle the degree of uncertainty investors have in the probabilities they use to make decisions, has been at all-time highs in recent months, indicating that there’s more fear built into the stock market than common measures of volatility suggest.

The decline in the VIX this year has befuddled investors and traders of all stripes, given the host of geopolitical uncertainties in locations like North Korea and political skirmishes in Washington.

Not to mention, stocks have been rising relentlessly for years, unnerving some investors who say that stocks are trading too high relative to expected earnings.

As The Wall Street Journal reports, two academics are rolling out a new measure of market fear that suggests investors aren’t nearly as complacent as they seem.

In separating out ambiguity from common measures of risk, Menachem Brenner of New York University and Yehuda Izhakian of Baruch College are picking up on a concept that traces back nearly a century.

Economist Frank Knight in 1921 wrote about the difference between risk and uncertainty.

If volatility measures the uncertainties for which one can determine a probability, or the “known unknowns,” ambiguity measures the “unknown unknowns,” to use a term popularized by former Defense Secretary Donald Rumsfeld, according to Mr. Brenner.

In October, the gauge hit 2.42, its highest reading in monthly data that extends back to 1993. That’s above the gauge’s previous peak of 2.41 at the height of the financial crisis in October 2008.

While none of the academics is willing to call a 'top' or any imminent decline, it is noteworthy that this new measure quantifies what many have noted - that market-based 'non-normal' tail risk remains elevated while 'normal risk' is repressed.

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Full "Asset Pricing and Ambiguity: Empirical Evidence" paper below:

Comments

Let it Go Wed, 12/13/2017 - 18:46 Permalink

Don't worry be happy is the mantra of the day but note that time has a way of revealing certain realities and the economy is far from a well-oiled and designed machine. In the end, we may find that it is not really completely under the control of those who have been placed in the driver's seat.In a world where central banks have become so deeply involved in manipulating and distorting markets we find true price discovery no longer exist. The question remains how best to prepare for an economic meltdown. Expect both luck and caution to play a big role in our individual fortunes as we move through the financially violent period before us. More on this subject below. http://The Catalyst Of Our Economic Demise has Yet To Be Determined .html