Last week we set out a very compressed history of Extreme Value Theory (EVT) from its genesis in 1928 to the present. In this week’s installment, we travel back in time to see what our risk technology, based on EVT and Expected Shortfall (ES), would have told a US equity investor in the run-up to the 1929 Crash.
That event, in common with other market crashes, was fueled by ‘irrational exuberance’ and a high degree of leverage. As legend has it, even the shoe-shine boys were buying shares on margin and Joseph P. Kennedy decided to exit the market when he started receiving stock tips from them. It is certainly the case that ‘smart money’ moved out of the market prior to October 1929. One would expect therefore to see some statistical evidence of increasing risk reflected in market prices.
This expectation is reinforced by examining the historic annualized return on the Dow Jones Index in the decade prior to the Crash. On three previous occasions when the annualized return had exceeded 40% there was a significant reversal. By September 1929 the annualized return on the Index hit 71%. Prominent Yale Economist Irving Fisher published an article explaining that a permanently high plateau in US equity prices had been achieved. What could possibly go wrong? Read the full article here.
Our EVT series will conclude next week.
Ana Cascon and William F. Shadwick are with Omega Analysis Limited in London, England. Their Book, The Right Answers To The Wrong Questions, is represented by Sophie Hicks at the Ed Victor Agency, London.