Global Risk Appetite Remains On Course For Panic

According to Credit Suisse Group AG, global risk appetite is on course for "panic". This observation is based on CS's proprietary Global Risk Appetite Index (GRAI), which has been constructed using data going back to the early 80s.

The bank doesn't reveal how it calculates the GRAI exactly, but it explains that the:

...GRAI is the slope of a cross-sectional, weighted, linear regression of a 6-month excess return measure (y-axis) on 12-month price variability (x-axis). This regression is estimated daily using rolling windows of data.

Currently, the returns of 64 country-based assets are used in the calculation. The constituents are broad equity and government bond indexes from developed countries and many of the more important and accessible emerging markets. These assets form a relatively continuous spectrum of risk from safer G3 bond indexes to riskier EM or peripheral European equity indexes. However, their positions along the risk spectrum do shift over time, but the 12-month calculation period ensures this is more gradual than the changes in return measures.

A weighting scheme is applied in the regression based upon the market capitalization and GDP of the countries of the respective assets. Thus the bond and equity indexes from the USA have a greater impact than those of Belgium.

For convenience we call periods when the CS GRAI is abnormally high (above 5) “euphoria” and abnormally low periods (below minus 3) “panic.”

A blog on the FT's Alphaville site, published at the end of 2014, shed a bit more light on the data that goes into the study:

We think of risk appetite indices as indicators of market sentiment, not indicators of economic growth, market valuation, or policy surprises. Good asset allocation decisions usually need to consider all of the above, but sharp spurts of relative underperformance in high volatility assets tend to be reversed quickly, so risk appetite can be a contrarian lead indicator for market performance when it gets to extremes.

Global risk appetite has been impacted by the combination of sharp declines in certain high-volatility emerging equity markets...

Panic: Time to buy?

The last time the indicator moved to the "panic" region by dropping below three was at the beginning of August 2011, when the Eurozone debt crisis, US debt ceiling debacle and the increasingly weak-looking global economy sent shares tumbling around the world. However, soon after the Credit Suisse Global Risk Appetite index plunged below three, the markets began to stage a recovery.

The same thing happened two years before. The Risk Appetite index hit "panic" during March 2009 and this marked the bottom of the market.

So, based on historic trends it's likely that investor sentiment will deteriorate further to "panic" levels, but soon after, history suggests that the markets will stage a recovery.

Here's where the index currently stands: