>INDIA STRATEGY: Chart Focus – Evaluating Tail Risk

The Debate: Is the market ignoring the macro pressures on inflation and the micro pressures on profit growth, especially given the premium valuations for equities? Hence, is the market set up for a big sell-off?

Market View: The market has reacted nonchalantly to a tepid earnings season, especially with the larger companies tending to disappoint on earnings. While inflation is a concern, the market seems to hold the view that the pressures will recede, and hence that India’s premium multiples will continue.

Our View: The 99%/1-week VAR (value-at-risk) represents the weekly market move that has a 1%
probability – i.e., the tail risk. When the historical VAR falls, it suggests that the market is increasingly complacent about tail risks. The 99%/1-week VAR is at a level which is consistent with a large sell-off. Going back 25 years, there are seven occasions when the VAR was at its current level (of less than 6%). Eventually, when VAR rises from this level, the market sells off 10% on an
average in a week (with the seven data points ranging from -5% to -13% – Exhibit 2). Note, though, that the historical VAR can remain at low levels for many weeks before culminating in a sell-off (on an average of 65 weeks!). VAR is a good indicator for impending tail risk, but it is not useful for timing the event. Fundamentally, India’s tail risk emanates from either a sharp world recovery (leading to inflation) or a “double dip” (causing a shortfall in funding for the current account).

Conclusion: While tail risk is in play, we do not believe that the market is likely to sell off in a big way anytime in the near future. The market is likely to reach higher levels before such a sell-off happens. History tells us that we may have to wait another year or for another 50% rise in index levels before tail risks play out. The market has spent only six weeks so far at the current VAR level, vs. the historical average of 65 weeks.

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