Worst case scenario is most likely to be avoided

This is the worst financial crises since the great depression and now is clear that its not only about Wall Street but Main Street is hit badly as well. Again George Soros and Nouriel Rubini were right. But is not end of the world.

Today I was listening to Mohamed El-Erian co Head of Pimco (link here). I must admit I really like his suggestions to help global financial system. In his opinion today’s coordinated global central banks effort to liquidate the world financial system was step in right direction. But it still looks like all taken measures are not sufficient to prevent the worst case scenario. Mohamed is calling for emergency package which would include coordinated interest rate cut across the globe and capital injection. I think that the package which he called “4 bazookas fired at once” is type of the solution which is urgently needed now.

Although the current drop in stock indexes may be felt as disaster but it is not. Let’s put current situation into perspective. The chart shows the cumulative loss from the last maximum to the next minimum of the S&P500 index over the period of last 40 years. This statistics is called Drawdown. Drawdown is defined as a persistent decrease in the price over consecutive days and its distribution measures how the successive descents influence each other.

At normal times assumption about independence between the successive returns holds very well. However the large drops are not independent. At “special” times they may be burst of local dependence of the returns. In other words large loses can generate even bigger loses. It may be explained by psychological crowding effect or by risk management rules (stop loses triggering) etc. In last 40 years biggest drawdown took 33% of its value within 4 days.

So far FED, US Treasury and most recently ECB, BOJ, BOE actions prevents worst case scenario to materialize. But authorities must stay ahead of the curve and additional measures are needed (4 bazookas). I convinced that all needed measures will be implemented and floor for the global indexes will be put around current levels.