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# Market Correction or Overreaction?

03/02/2020 12:58 PM

Market Correction or Overreaction?
Kamakura Troubled Company Index Increases by 10.04% to 23.79%
Credit Quality Drops to 14th Percentile

NEW YORK, March 2, 2020: In his classic book “The Intelligent Investor,” published in 1949, author Benjamin Graham offers a colorful illustration of the concept of market value that still holds water today.

Graham asks readers to imagine they have an investment partner named Mr. Market, who every day offers to buy them out of their position or sell them additional shares. While his proposals often seem reasonable, he sometimes “lets his enthusiasm or fears run away with him,” leading to valuations that seem “a little short of silly.”

The Kamakura Troubled Company Index® showed a large jump in default risk for the second consecutive month, with a 10.04% rise to 23.79%, resulting in a drop in credit quality from the 34th percentile to the 14th percentile. The index also displayed a large jump in volatility, ranging during the month from 11.51% to 23.79%. The index reflects the percentage of 40,500 public firms that have a default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

At the close of February, the percentage of companies with a default probability between 1% and 5% was 17.44%, an increase of 6.53% over the month. The percentage with a default probability between 5% and 10% was 3.62%, an increase of 1.87%. Those with a default probability between 10% and 20% amounted to 1.89% of the total, an increase of 1.04%; and those with a default probability of over 20% amounted to 0.84%, an increase of 0.60% from the prior month. While default probabilities increased across the spectrum, the largest jump was for those in the 1%-to-5% category, indicating an increase in firms showing early signs of stress.
At 23.79%, the Troubled Company Index fell to 14th percentile of historical credit quality as measured since 1990.

Among the 10 riskiest-rated firms listed in February, six are in the U.S, with. one each in Canada, Luxembourg, Spain, and the UK. The riskiest rated company in our coverage universe was Chaparral Energy Inc. (NYSE:Chap), with a one-year KDP of 52.99% up 16.98% over the past month. Deoleo SA remained the riskiest firm as measured by the one-month KDP, coming in at 58.05%. Seven of the 10 riskiest firms are in the energy sector. Looking at firms’ short-term (30-day KDP) default probability, we saw an even larger one-month jump in risk. You can see these results in the charts below. We had six defaults in our coverage universe, with four in the U.S. and one each in the UK and Mexico.

Ten Riskiest Rated Firms – 1-Year KDP

Ten Riskiest Rated Firms – 1-Month KDP

The Kamakura expected cumulative default curve for all rated companies worldwide widened, with the one-year expected default rate increasing by 0.91% to 2.2% while the 10-year rate increased by 0.59% to 14.82%.

Commentary
By Martin Zorn, President and Chief Operating Officer, Kamakura Corporation

Why use quantitative models? Expert judgement-based models like ratings have been around for a long time. Quite often I have heard people reject quantitative model results as not being intuitive. This week the S&P 500 lost 11.49% of value and the 10-year Treasury yield dropped to a record low of 1.31%. Keeping in mind Benjamin Graham’s comments about market movements, were the week’s results a product of irrational fear, or were they the beginning of a justified correction to irrational exuberance in the valuations of the week before?

I am a by-product of my 21 years with the “old” Wachovia bank, which believed in “soundness, profitability and growth – in that order.” In other words, I believe in underwriting credit fundamentals that include sovereign and country risk, industry risk, market risk. and company-specific risk. As an underwriter, you are repaid by cash flow from operations as your primary source of debt repayment, and you also have a good understanding of the secondary sources available as measures of financial flexibility. As a portfolio manager, you understand that “your first loss is usually your best loss.” Another way of putting that is, “Hope is not a strategy.” Hype does not pay you back.

In thinking about my credit fundamentals, I owe a debt of gratitude to Bo Brookby, who was for many years my counterpart in loan administration at Wachovia. I also owe a debt of gratitude to my current boss, Kamakura Founder Dr. Donald van Deventer, and to our Managing Director of Research, Professor Robert Jarrow. These men taught me the importance of best practice quantitative modeling, which allows you to deal with facts and data without the biases that opinions bring to the table. As Walt Disney said, “Get a good idea and stay with it. Dog it and work it until it’s done, and done right”.

This week we saw a correction in the market. Was it the turning point or an overreaction? Time will answer that question. During the past two months we have seen a significant uptick in short term default probabilities. Is this a turning point in a long period of benign credit conditions or simply a bump in the road? Low interest rates, tight spreads and covenant-lite loan structures have made debt service pretty easy to meet. Expansive capital markets and easy underwriting standards have made refinancing readily available.

The coronavirus and the uncertainties around it have galvanized thinking around fundamental economic growth. You cannot have fundamental operating cash flow without sales. During the past two months, we saw companies with large jumps in their one-month and one-year Kamakura Default Probabilities (KDP), but we also saw companies with large declines in their KDPs, even in industries such as energy, which were adversely impacted by market events. These results are a clarion call to fundamental analysis using all of the tools available. It is in periods of uncertainty and volatility when we can best differentiate between horsepower and tailwind.

The Kamakura Troubled Company Index® measures the percentage of 40,575 public firms in 76 countries that have an annualized one- month default risk of over one percent. The average index value since January 1990 is 14.36%. Since November 2015, the Kamakura index has used the annualized one-month default probability produced by the KRIS version 6.0 Jarrow-Chava reduced form default probability model, a formula that bases default predictions on a sophisticated combination of financial ratios, stock price history, and macro-economic factors.

The KRIS version 6.0 models were developed using a data base of more than 2.2 million observations and more than 2,600 corporate failures. A complete technical guide, including full model test results and parameters, is provided to subscribers. The KRIS service also includes a wide array of other default probability models that can be seamlessly loaded into Kamakura’s state-of-the-art enterprise risk management software engine, the Kamakura Risk Manager. Available models include the non-public-firm default model, the commercial real estate model, the U.S. bank model, and the sovereign model. Related data includes credit default swap trading volume by reference name, market implied credit spreads, and prices on all traded corporate bonds traded in the U.S. market. Macro factor parameter subscriptions include Heath, Jarrow, and Morton term structure models for government securities in the U.S., Germany, the UK, Canada, Spain, Sweden, Australia, Japan, Thailand, and Singapore. All parameters are derived in a no-arbitrage manner consistent with seminal papers by Heath, Jarrow, and Morton, as well as Amin and Jarrow. A KRIS Macro Factor Scenario Service subscription includes both riskneutral and “real world” empirical scenarios for interest rates and macro factors.

The version 6.0 model was estimated over the period from 1990 to May 2014 and includes the insights of the entirety of the recent credit crisis. The 76 countries currently covered by the index are: Argentina, Australia, Austria, Bahrain, Bangladesh, Belgium, Belize, Botswana, Brazil, Bulgaria, Canada, Chile, China, Colombia, Croatia, Cyprus, Czech
Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Ghana, Greece, Hungary, Hong Kong, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kenya, Kuwait, Luxembourg, Malaysia, Malta, Mauritius, Mexico, Nigeria, the Netherlands, New Zealand, Norway, Oman, Pakistan, Peru, the Philippines, Poland,
Portugal, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Tanzania, Taiwan, Thailand, Turkey, the United Arab Emirates, Uganda, the UK, the U.S., Vietnam and Zimbabwe.

The version 6.0 model was estimated over the period from 1990 to May 2014 and includes the insights of the entirety of the recent credit crisis. The 76 countries currently covered by the index are: Argentina, Australia, Austria, Bahrain, Bangladesh, Belgium, Belize, Botswana, Brazil, Bulgaria, Canada, Chile, China, Colombia, Croatia, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Ghana, Greece, Hungary, Hong Kong, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kenya, Kuwait, Luxembourg, Malaysia, Malta, Mauritius, Mexico, Nigeria, the Netherlands, New Zealand, Norway, Oman, Pakistan, Peru, the Philippines, Poland, Portugal, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Tanzania, Taiwan, Thailand, Turkey, the United Arab Emirates, Uganda, the UK, the U.S., Vietnam and Zimbabwe.

To follow the troubled company index and other risk commentary by Kamakura on a daily basis, please follow:

Kamakura CEO Dr. Donald van Deventer (www.twitter.com/dvandeventer)

Founded in 1990, Honolulu-based Kamakura Corporation is a leading provider of risk management information, processing, and software. Kamakura was recognized as a category leader in the Chartis Report, Technology Solutions for Credit Risk 2.0 2018. Kamakura was named to the World Finance 100 by the editor and readers of World Finance magazine in 2017, 2016 and 2012. In 2010, Kamakura was the only vendor to win two Credit Magazine innovation awards. Kamakura Risk Manager, first sold commercially in 1993 and now in version 10.0.3, is the first enterprise risk management system for users focused on credit risk, asset and liability management, market risk, stress testing, liquidity risk, counterparty credit risk, and capital allocation from a single software solution. The
KRIS public firm default service was launched in 2002. The KRIS sovereign default service, the world’s first, was launched in 2008, and the KRIS nonpublic firm default service was offered beginning in 2011. Kamakura added its U.S. Bank default probability service in 2014.

Kamakura has served more than 330 clients with assets ranging in size from $1.5 billion to$3.0 trillion and fund managers with Assets Under Management in excess of \$26 trillion. Its risk management products are currently used in 47 countries, including the United States, Canada, Germany, the Netherlands, France, Austria, Switzerland, the United Kingdom, Russia, Ukraine, South Africa, Australia, China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, Singapore, Sri Lanka, Taiwan, Thailand, Vietnam, and many other countries in Asia, Europe and the Middle East.

To follow risk commentary by Kamakura on a daily basis, please follow:
Kamakura CEO Dr. Donald van Deventer (www.twitter.com/dvandeventer)