Posts Tagged ‘Interpret’

How to Use RRG Charts in Trading

Written by admin. Posted in Technical Analysis

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The relative rotation graph (RRG) is a sophisticated tool in technical analysis to help investors decide which sectors, individual stocks, and other assets to pursue. Investors can use it to visually compare the performance and momentum of securities and asset classes against a benchmark. RRGs plot assets on a two-dimensional graph, with the x-axis representing the relative strength ratio and the y-axis for relative strength momentum. This format enables traders and investors to visually assess the relative strength and trendline of different securities, making it valuable for trading, rotation, and asset allocation strategies.

Key Takeaways

  • The relative rotation graph (RRG) is a chart used in technical analysis to test the performance and momentum of securities or asset classes against a benchmark.
  • RRGs provide a comprehensive view of the market, helping investors to spot trends, compare multiple securities simultaneously, and make more informed decisions when rebalancing portfolios.
  • RRGs should be used with other forms of analysis since they are a partial view of the market.
  • Several tools and resources are available to create and analyze RRGs, ranging from professional-grade software from Bloomberg and Optuma to more accessible platforms like StockCharts.com.

What is the Relative Rotation Graph?

RRGs are used to identify which stocks or sectors are underperforming and outperforming a market index or benchmark. The RRG has four quadrants: leading, weakening, lagging, and improving. Each quadrant is for different stages of an asset’s performance cycle, providing insights into the rotation of market leadership. This movement of securities through the quadrants helps to spotting trends and potential reversals and could provide investors with a strategic advantage in both short-term and long-term trading.

RRGs were created by Julius de Kempenaer in the early 1990s to visualize the relative performance of stocks and other securities against a benchmark and each other. De Kempenaer’s work has been valuable for helping investors make more informed decisions about trading, rotation, and asset allocation.

RRGs are an excellent visual way of analyzing market trends and relative performance. However, like all technical tools, they should be used with other techniques for a more comprehensive approach to trading and investing.

Understanding the Parts of the Relative Rotation Graph

The key elements of RRG and how they indicate relative strength and momentum are as follows:

  • Axes: The x-axis is the relative strength ratio. This axis measures the performance of a security relative to a benchmark (hence, the strength is “relative”). A value more than 100 indicates outperformance, while a value less than 100 indicates underperformance. The y-axis represents the momentum of the relative strength. This axis shows the rate of change in the relative performance. It is essentially the momentum of the relative strength ratio,
  • Top right quadrant: The top right quadrant in the RRG is the leading quadrant. Securities in this quadrant are outperforming the benchmark, and their momentum is positive. This indicates strong and improving performance.
  • Bottom right quadrant: The bottom right quadrant is the weakening quadrant. Here, securities are still outperforming the benchmark, but their momentum is decreasing. Being here suggests that while they are strong, they might be losing their edge.
  • Bottom left quadrant: This is the lagging quadrant. Securities in this area are underperforming the benchmark with negative momentum. It is a sign of weakness.

  • Top left quadrant: This is the improving quadrant. This quadrant contains securities that are underperforming the benchmark but show increasing momentum. Being here suggests the potential for a turnaround.
  • Data points and movement: Each security or asset is represented as a data point on the graph. The position of a data point within the graph indicates its relative strength and momentum. The movement of these data points is tracked over time, usually in a clockwise direction through the quadrants, which illustrates the evolution of their relative performance.

RRGs help investors spot trends and compare several securities at once. However, RRGs should be used with other forms of analysis since they provide a relative, not absolute, view.

How to Interpret Relative Rotation Graphs

Interpreting RRGs involve analyzing the patterns and movements of securities on this chart to identify market leaders, laggards, and potential rotation opportunities.


Weekly Relative Rotation Graph of Magnificent Seven Stocks as at 18th December 2023.

stockcharts.com


Movements and Patterns in RRGs

Securities in the RRG generally move clockwise through the four quadrants. This rotation reflects the natural ebb and flow of securities’ relative strength and momentum relative to a benchmark. In addition, the further a security is from the center, the stronger its relative strength or weakness is compared with the benchmark. A security far out in the leading or lagging quadrant has a strong trend, whether positive or negative.

The speed at which a security moves through the quadrants can indicate the stability of its trend. Rapid movements might suggest more volatile or less stable trends. Indeed, many RRGs show tails behind the data points, representing their historical path. Longer tails provide more context on historical performance and trend stability.

Identifying Market Leaders and Laggards

Securities in the leading quadrant are outperforming the benchmark with positive momentum and are considered market leaders. A security with a presence or movement deeper into this quadrant suggests a strong and stable outperformance. Meanwhile, securities in the lagging quadrant are underperforming and have negative momentum. These are the laggards of the market. A security that is continuously in or moving deeper into this quadrant has a strong downtrend relative to the benchmark.


Monthly US Sector Rotation as at December 1 2023.

stockcharts.com


Identifying Rotational Opportunities

A security moving from the improving quadrant into the leading quadrant can be an opportunity. This shift indicates a security is starting to outperform the benchmark with increasing momentum. Similarly, a security moving from the weakening to the lagging quadrant suggests that its previous outperformance is deteriorating, and it is now starting to underperform. This could signal a selling opportunity or a warning to avoid new investments.

Meanwhile, a move from lagging to improving suggests that a security is beginning to reverse its underperformance. This indicates an early stage of recovery, a potential buying opportunity for contrarian investors. Also, securities shifting from leading to weakening are still outperforming but are losing momentum. This could be a signal to take the profits or closely watch the situation to see if it continues losing steam.

Using Relative Rotation Graphs with Other Technical Tools

RRGs can be more effective when put together with other charts in the technical analyst’s toolkit. For example, once an RRG helps determine sectors or stocks that are showing relative strength, you can then review stocks in those sectors in greater depth. Candlestick patterns and volume analysis can give more details on the trading behavior for specific stocks, clueing you in about potential reversals in price trends. Indicators like moving averages, the relative strength index (RSI), and Bollinger Bands can also be used to assess the momentum and volatility of these stocks, helping you decide on entries and exits.

In addition, the RRG’s ability to depict sector rotation can provide great help for those using a top-down investment approach. When showing the sectors moving into the leading quadrant, you might allocate more to sectors poised for growth and reduce your exposure to those going into the lagging quadrant. This sector rotation strategy can be particularly useful during different phases of the economic cycle, as certain sectors tend to do better than others based on the economic conditions. This then points to how fundamental analysis can be used with RRG for a fuller picture of particular sectors and their prospects.

Benefits and Limitations of Relative Rotation Graphs

RRGs offer several advantages and limitations when used in trading, analysis, and portfolio management. Understanding these can help make better use of them for investing.

Benefits and Limitations of Relative Rotation Graphs

Benefits

  • Easy Visualization of Market Dynamics

  • Comparison Tool

  • Helps Identify Trends

  • Helps with Timely Decision Making

  • Complements Other Analysis

  • Helps with Deciding Asset Allocation

Limitations

  • Shows Relative, Not Absolute Rotation

  • Lagging Indicator

  • Requires a Benchmark

  • Not a Standalone Tool

  • Provides no Indication of Value

Benefits of Relative Rotation Graphs

Here are some benefits of RRGs:

  • Visualizing market dynamics: RRGs provide a clear, visual representation of the relative strength and momentum of various securities or sectors, making it easier to understand complex market moves.
  • Comparison tool: With RRGs, you can compare several securities simultaneously against a benchmark, which can be valuable for portfolio diversification and sector rotation strategies.
  • Identifying trends: RRGs help pick out leaders, laggards, and emerging trends by observing the movement of securities through different quadrants.
  • Timely decision-making: The dynamic nature of RRGs aids investors in making timely decisions by highlighting changes in momentum and strength before they become evident through price movements alone.
  • Complementing other analyses: RRGs can be used alongside other technical, fundamental, and quantitative analysis tools, providing a more holistic view of the market.
  • Sector and asset allocation: RRGs are particularly useful for sector analysis and distributing assets since they help identify industries or asset classes likely to outperform or underperform.

Limitations of Relative Rotation Graphs

Here are some limitations of RRGs:

  • Relative, not absolute, rotation: RRGs illustrate the performance relative to a benchmark, not the absolute performance. A security in the leading quadrant could still be losing value in a bear market.
  • Lagging indicator: RRGs inherently lag. They reflect past performance and trends, which may not always predict future movements.
  • Requires a benchmark: The effectiveness of RRGs depends on the choice of an appropriate benchmark, which can vary based on the assets.
  • Not a stand-alone tool: RRGs should not to be used in isolation. They do not deliver insights into company fundamentals, macroeconomic conditions, or market sentiment.
  • No indication of value: RRGs do not provide information about the value of securities. A stock might be moving into the leading quadrant but still be overpriced.

While RRGs are powerful for visualizing and analyzing market trends and relative performance, they are most effective when used as part of a broader, diversified approach to investment analysis and decision-making. Understanding their limitations is crucial to avoid overestimating their relevance.

Differences Between the Relative Rotation Graph and the Relative Strength Index

The Relative Rotation Graph vs. the Relative Strength Index

Relative Rotation Graph (RRG)

  • Scope: RRG is used to compare several securities against a benchmark.

  • Dimensions: RRG provides a two-dimensional view.

  • Interpretation: RRG is better for relative performance and identifying trends.

  • Usage: RRG is typically used for asset allocation and sector rotation.

Relative Strength Index (RSI)

  • Scope: The RSI is used for analyzing the price momentum of a single security.

  • Dimensions: The RSI is a one-dimensional oscillator.

  • Interpretation: The RSI illustrates momentum and potential price reversals.

  • Usage: RSI is commonly used to identify potential entries and exits.

The RRG and the relative strength index (RSI) are both used in technical analysis, but serve different purposes and provide different kinds of information. RRGs are used for comparing several securities against a benchmark, while the RSI is for analyzing the price momentum of a single security. In addition, RRGs offer a two-dimensional view (strength and momentum), while the RSI is a one-dimensional oscillator (it constructs high and low bands and provides a trend indicator).

RRG is best used for relative performance and identifying trends. Meanwhile, the RSI is best for ascertaining momentum and potential price reversals. Another set of differences is that RRG is often used for asset allocation and sector rotation, while the RSI commonly helps identify potential entries and exits.

As such, RRG is more for visualizing and comparing the relative strength and trends of multiple securities, and the RSI sets out the momentum of individual securities and can help identify when there are overbought or oversold conditions.

Resources for Creating Relative Rotation Graphs

Making your RRGs requires specialized tools and resources, as these graphs involve complex calculations and dynamic visuals. Here are some great tools to use:

  • RRG Research: Founded by Julius de Kempenaer, the creator of RRGs, the firm’s site provides tools and insights related to RRGs. The website offers educational resources, analysis, and access to RRGs.
  • Bloomberg Professional Services Software: The Bloomberg Professional Services software, a leading financial data and analytics platform, offers RRG charts as part of its services. It provides functions for creating and customizing RRGs, making it a popular choice among professional investors and analysts.
  • Refinitiv Eikon: This platform is another leading financial data and analytics provider that offers RRG charts as part of its services.
  • StockCharts.com: This online platform offers various chart tools, including RRGs. It has a user-friendly interface for creating RRGs, suitable for professionals and individual investors.
  • Optuma: Optuma is a professional-level technical analysis software that includes RRGs among its features. Known for its advanced analysis tools, Optuma caters to professional traders and analysts.

The tool you choose depends on your needs, skill level, and access to resources.

Which Technical Analysis Indicators Work Well with Relative Rotation Graphs?

Combining RRGs with other indicators can provide a more comprehensive view of the market and help refine investment strategies. Some indicators include moving averages, the RSI, the moving average convergence divergence, Bollinger Bands, support and resistance levels, and other chart patterns.

What Asset Groups Work Well with Relative Rotation Graphs?

RRGs are best used to analyze asset groups when relative performance is key. These can include equity sectors and industries, exchange-traded funds, indexes, benchmarks, fixed-income securities, commodities, and currencies. RRGs’ ability to compare several assets simultaneously makes them invaluable for a wide range of investment strategies from picking individual stocks to deciding on broad asset allocations. However, with all financial and investment tools, they should be used as part of a broader, diversified approach to market analysis and not relied upon in isolation.

Which Benchmarks Work Well with Relative Rotation Graphs?

The benchmark chosen is critical in interpreting RRGs, setting the standard against which the other securities or asset classes are measured. The benchmark to use depends on the type of assets being analyzed and the specific goals of the analysis. Some commonly used benchmarks include broad market, sector, fixed-income, commodity, regional, country-specific, currency, real estate, and thematic indexes.

How Can the Reliability of Relative Rotation Graphs Be Improved?

Increasing the reliability of RRGs involves choosing the right benchmarks, using quality data, understanding the tool’s limitations, and integrating it with other forms of analysis. Regular reviews, adaptation to changing market conditions, and ongoing education are essential for effectively using RRGs in trading and investments.

The Bottom Line

RRGs are vital for some types of technical analysis, offering a way to visualize the relative performance and momentum of different securities against a chosen benchmark. Its design, characterized by placing securities in four distinct quadrants—labeled leading, weakening, lagging, and improving—allows traders and investors to quickly grasp shifts in the market and identify assets gaining or losing strength against others. This makes RRGs particularly useful for strategies involving sector rotation, asset allocation, and portfolio diversification.

For traders, RRGs provide a strategic edge by enabling a clear understanding of various market segments’ relative trends and strengths. By integrating RRG analysis with other technical indicators and fundamental insights, traders can identify potential entry and exit points more effectively.

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The Ascending Triangle Pattern: What It Is, How To Trade It

Written by admin. Posted in A, Financial Terms Dictionary

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What Is an Ascending Triangle?

An ascending triangle is a chart pattern used in technical analysis. It is created by price moves that allow for a horizontal line to be drawn along the swing highs and a rising trendline to be drawn along the swing lows. The two lines form a triangle. Traders often watch for breakouts from triangle patterns. The breakout can occur to the upside or downside.

Ascending triangles are often called continuation patterns since price will typically break out in the same direction as the trend that was in place just prior to the triangle forming.

An ascending triangle is tradable in that it provides a clear entry point, profit target, and stop-loss level. It may be contrasted with a descending triangle.

Key Takeaways

  • The trendlines of a triangle need to run along at least two swing highs and two swing lows.
  • Ascending triangles are considered a continuation pattern, as the price will typically break out of the triangle in the price direction prevailing before the triangle, although this won’t always occur. A breakout in any direction is noteworthy.
  • A long trade is taken if the price breaks above the top of the pattern.
  • A short trade is taken if the price breaks below the lower trendline.
  • A stop loss is typically placed just outside the pattern on the opposite side from the breakout.
  • A profit target is calculated by taking the height of the triangle, at its thickest point, and adding or subtracting that to/from the breakout point.

What Does the Ascending Triangle Tell You?

An ascending triangle is generally considered to be a continuation pattern, meaning that the pattern is significant if it occurs within an uptrend or downtrend. Once the breakout from the triangle occurs, traders tend to aggressively buy or sell the asset depending on which direction the price broke out.

Image by Julie Bang © Investopedia 2019


Increasing volume helps to confirm the breakout, as it shows rising interest as the price moves out of the pattern.

A minimum of two swing highs and two swing lows are required to form the ascending triangle’s trendlines. But a greater number of trendline touches tends to produce more reliable trading results. Since the trendlines are converging on one another, if the price continues to move within a triangle for multiple swings, the price action becomes more coiled, likely leading to a stronger eventual breakout.

Volume tends to be stronger during trending periods than during consolidation periods. A triangle is a type of consolidation, and therefore volume tends to contract during an ascending triangle. As mentioned, traders look for volume to increase on a breakout, as this helps confirm the price is likely to keep heading in the breakout direction. If the price breaks out on low volume, that is a warning sign that the breakout lacks strength. This could mean the price will move back into the pattern. This is called a false breakout.

For trading purposes, an entry is typically taken when the price breaks out. Buy if the breakout occurs to the upside, or short/sell if a breakout occurs to the downside. A stop loss is placed just outside the opposite side of the pattern. For example, if a long trade is taken on an upside breakout, a stop loss is placed just below the lower trendline.

A profit target can be estimated based on the height of the triangle added or subtracted from the breakout price. The thickest part of the triangle is used. If the triangle is $5 high, add $5 to the upside breakout point to get the price target. If the price breaks lower, the profit target is the breakout point less $5.

Example of How to Interpret the Ascending Triangle

Investopedia / Sabrina Jiang


Here an ascending triangle forms during a downtrend, and the price continues lower following the breakout. Once the breakout occurred, the profit target was attained. The short entry or sell signal occurred when the price broke below the lower trendline. A stop loss could be placed just above the upper trendline.

Wide patterns like this present a higher risk/reward than patterns that get substantially narrower as time goes on. As a pattern narrows, the stop loss becomes smaller since the distance to the breakout point is smaller, yet the profit target is still based on the largest part of the pattern.

The Difference Between an Ascending Triangle and a Descending Triangle

These two types of triangles are both continuation patterns, except they have a different look. The descending triangle has a horizontal lower line, while the upper trendline is descending. This is the opposite of the ascending triangle, which has a rising lower trendline and a horizontal upper trendline.

Limitations of Trading the Ascending Triangle

The main problem with triangles, and chart patterns in general, is the potential for false breakouts. The price may move out of the pattern only to move back into it, or the price may even proceed to break out the other side. A pattern may need to be redrawn several times as the price edges past the trendlines but fails to generate any momentum in the breakout direction.

While ascending triangles provide a profit target, that target is just an estimate. The price may far exceed that target, or fail to reach it.

Psychology of the Ascending Triangle

Like other chart patterns, ascending triangles indicate the psychology of the market participants underlying the price action. In this case, buyers repeatedly drive the price higher until it reaches the horizontal line at the top of the ascending triangle. The horizontal line represents a level of resistance—the point where sellers step in to return the price to lower levels.

As the price drops downward from the horizontal resistance level, buyers begin to show their resolve, and the price fails to reach the recent low, with the trend turning upward once again at a higher swing low. In other words, the upward-sloping trendline that forms the lower boundary of the ascending triangle is acting as support—the level where buyers jump in and prevent the price from falling any lower.

In a well-defined ascending triangle pattern, the price bounces between the horizontal resistance line and the lower trendline. The lines of the triangle eventually converge, setting the stage for a showdown between upward and downward pressure that could determine which direction the price will move out of the pattern. As it approaches the vertex of the triangle, the price will either break out above the resistance level, suggesting additional gains ahead, or it will fall below the support level, increasing the likelihood that the price will decline.

What Is a Continuation Pattern?

When you identify a continuation pattern on a chart, it suggests that the price of the asset has a greater likelihood of emerging from the pattern in the same direction that it was moving previously. There are several continuation patterns, including the ascending triangle, that technical analysts use as signals that the existing price trend will likely continue. Other examples of continuation patterns include flags, pennants, and rectangles.

What Are Support and Resistance Levels?

Support and resistance levels represent points on a price chart where there is a likelihood of a letup or a reversal of the prevailing trend. Support occurs where a downtrend is expected to pause due to a concentration of demand, while resistance occurs where an uptrend is expected to pause due to a concentration of supply. In an ascending triangle pattern, the upward-sloping lower trendline indicates support, while the horizontal upper bound of the triangle represents resistance.

How Do You Trade the Ascending Triangle Chart Pattern?

Traders generally enter a position on a security when its price breaks above or below the boundaries of an ascending triangle. If the price jumps above the horizontal resistance level, it may be a good time to buy, while a move below the lower trendline suggests that selling or shorting the asset could be a profitable move. Traders often protect their positions by placing a stop loss outside the opposite side of the pattern. To determine a profit target, it can be useful to start at the breakout point and then add or subtract the height of the triangle at its thickest point.

The Bottom Line

An ascending triangle is a technical analysis chart pattern that occurs when the price of an asset fluctuates between a horizontal upper trendline and an upward-sloping lower trendline. Since the price has a tendency to break out in the same direction as the trend in place before the formation of the triangle, ascending triangles are often called continuation patterns. Traders often wait for the price to break above or below the pattern before entering a position. The ascending triangle pattern is particularly useful for traders because it suggests a clear entry point, profit target, and stop-loss level.

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Altman Z-Score: What It Is, Formula, How to Interpret Results

Written by admin. Posted in A, Financial Terms Dictionary

Altman Z-Score: What It Is, Formula, How to Interpret Results

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What Is the Altman Z-Score?

The Altman Z-score is the output of a credit-strength test that gauges a publicly traded manufacturing company’s likelihood of bankruptcy.

Key Takeaways

  • The Altman Z-score is a formula for determining whether a company, notably in the manufacturing space, is headed for bankruptcy. 
  • The formula takes into account profitability, leverage, liquidity, solvency, and activity ratios. 
  • An Altman Z-score close to 0 suggests a company might be headed for bankruptcy, while a score closer to 3 suggests a company is in solid financial positioning.

Understanding the Altman Z-Score

The Altman Z-score, a variation of the traditional z-score in statistics, is based on five financial ratios that can be calculated from data found on a company’s annual 10-K report. It uses profitability, leverage, liquidity, solvency, and activity to predict whether a company has a high probability of becoming insolvent.

NYU Stern Finance Professor Edward Altman developed the Altman Z-score formula in 1967, and it was published in 1968. Over the years, Altman has continued to reevaluate his Z-score. From 1969 until 1975, Altman looked at 86 companies in distress, then 110 from 1976 to 1995, and finally 120 from 1996 to 1999, finding that the Z-score had an accuracy of between 82% and 94%.

In 2012, he released an updated version called the Altman Z-score Plus that one can use to evaluate public and private companies, manufacturing and non-manufacturing companies, and U.S. and non-U.S. companies. One can use Altman Z-score Plus to evaluate corporate credit risk. The Altman Z-score has become a reliable measure of calculating credit risk.

How to Calculate the Altman Z-Score

One can calculate the Altman Z-score as follows:

Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

  • A = working capital / total assets
  • B = retained earnings / total assets
  • C = earnings before interest and tax / total assets
  • D = market value of equity / total liabilities
  • E = sales / total assets

A score below 1.8 means it’s likely the company is headed for bankruptcy, while companies with scores above 3 are not likely to go bankrupt. Investors can use Altman Z-scores to determine whether they should buy or sell a stock if they’re concerned about the company’s underlying financial strength. Investors may consider purchasing a stock if its Altman Z-Score value is closer to 3 and selling or shorting a stock if the value is closer to 1.8.

In more recent years, however, a Z-Score closer to 0 indicates a company may be in financial trouble. In a lecture given in 2019 titled “50 Years of the Altman Score,” Professor Altman himself noted that recent data has shown that 0—not 1.8—is the figure at which investors should worry about a company’s financial strength. The two-hour lecture is available to view for free on YouTube.

2008 Financial Crisis

In 2007, the credit ratings of specific asset-related securities had been rated higher than they should have been. The Altman Z-score indicated that the companies’ risks were increasing significantly and may have been heading for bankruptcy.

Altman calculated that the median Altman Z-score of companies in 2007 was 1.81. These companies’ credit ratings were equivalent to a B. This indicated that 50% of the firms should have had lower ratings, were highly distressed and had a high probability of becoming bankrupt.

Altman’s calculations led him to believe a crisis would occur and there would be a meltdown in the credit market. He believed the crisis would stem from corporate defaults, but the meltdown, which brought about the 2008 financial crisis, began with mortgage-backed securities (MBS). However, corporations soon defaulted in 2009 at the second-highest rate in history.

How Is the Altman Z-Score Calculated?

The Altman Z-score, a variation of the traditional z-score in statistics, is based on five financial ratios that can be calculated from data found on a company’s annual 10-K report. The formula for Altman Z-Score is 1.2*(working capital / total assets) + 1.4*(retained earnings / total assets) + 3.3*(earnings before interest and tax / total assets) + 0.6*(market value of equity / total liabilities) + 1.0*(sales / total assets).

How Should an Investor Interpret the Altman Z-Score?

Investors can use Altman Z-score Plus to evaluate corporate credit risk. A score below 1.8 signals the company is likely headed for bankruptcy, while companies with scores above 3 are not likely to go bankrupt. Investors may consider purchasing a stock if its Altman Z-Score value is closer to 3 and selling, or shorting, a stock if the value is closer to 1.8. In more recent years, Altman has stated a score closer to 0 rather than 1.8 indicates a company is closer to bankruptcy.

Did the Altman Z-Score Predict the 2008 Financial Crisis?

In 2007, Altman’s Z-score indicated that the companies’ risks were increasing significantly. The median Altman Z-score of companies in 2007 was 1.81, which is very close to the threshold that would indicate a high probability of bankruptcy. Altman’s calculations led him to believe a crisis would occur that would stem from corporate defaults, but the meltdown, which brought about the 2008 financial crisis, began with mortgage-backed securities (MBS); however, corporations soon defaulted in 2009 at the second-highest rate in history.

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