Fairy Tails: Lessons from 150 Years of Drawdowns

The authors identify, examine, and categorize the largest downside tail events in the US equity market over the past 150 years using monthly data. They define a downside tail event as any peak-to-trough loss of at least 15%. Using Gaussian mixture models to cluster the tail events based on predrawdown observables, five distinct environments emerge: hiking, easing, disinflationary, inflationary, and exuberance. The authors further distinguish gamma events as those in which a hedging policy of rolling short-term option positions would have recovered more than half of the drawdown and find that they all occur only in hiking or exuberance environments, with the exception of the 2020 COVID-19 lockdown event, which can be thought of as a “known unknown”. Such gamma events can be distinguished ex-ante from nongamma events with a two-factor logistic model based on the equity-fixed income correlation and the change in the geopolitical risk index over the year preceding the starting peak of the drawdown. A large increase in geopolitical risk and/or equity-fixed income correlation, reflective of a market environment driven by fewer factors and hence more fragile, indicates a greater likelihood that a future drawdown is of a gamma type. This model can help recommend if gamma or delta protection should be sought. Finally, in addition to categorizing and explaining the causes and drivers of downside tail events, we also determine which types of tail hedge strategies worked, and how well, for each tail event. The analysis provides important information to guide the use of tail-hedging strategies, which can accelerate compounding.