Risk -- and more accurately "visible risk" -- has re-entered the market, and that's a very good thing. Visible risk is what you can measure, evaluate, mitigate, manage, and hedge (at least to some degree).
Compare that to the alternative we've been saddled with for the past few years in the aftermath of the financial crisis - "complete uncertainty" - which amounts to flying blind into uncharted territory, with your only solace being a promise from the government that says it's here to help. (As late President Ronald Reagan observed, those are the scariest words in the English language.)
Thankfully, things are changing and we are in a new investment paradigm. Markets are a good mechanism for pricing risk -- uncertainty not so much. When faced with uncertainty, markets become volatile and follow irrational patterns. With visible risk, on the other hand, it is far easier to calculate the potential downside and invest accordingly.
If an investor has, say, $10,000 to invest and the potential risk is pegged 10% or even 20%, then the decision can be made: invest all of it and risk losing $1,000 or $2,000, or invest a portion. Thus, visible risk has been positive for the market because when investors have a better handle on the potential downside it encourages investment-as opposed to the unknown of complete uncertainty. With two months of 2013 under our belt, the market has made a solid move upward, with the S&P 500 Index showing a nearly 6% gain for the year thus far.
Going forward, with the return of visible risk, we can expect the market to react for real. As a fundamental, tactical investment manager, I couldn't be happier. Our approach is to analyze economic data and adjust portfolio beta accordingly, increasing or decreasing exposure as we interpret the signals. This time-tested approach, we believe, is one of the best ways to deal with risk, because it allows for investment decisions to be made based on economic reality.
The dominant reality for 2013 is all based on whether we will see a pickup in demand. Since the financial crisis, which was caused in many ways by consumer overindulgence in the past, there has been a decided lack of demand. The good news, we believe, is that there is pent-up demand, particularly for capital spending. A revision in Q4 2012 GDP brought the reading into slightly positive territory at +0.1% from an initial -0.1 %. The ISM's manufacturing purchasing managers' index increased to 54.2 in February from 53.1 in January. However, there have been some disappointments, most notably the Philadelphia Fed Business Index, which worsened and fell into contraction territory in January, and jobless claims recently showed an uptick.
On the political front, sequestration has had less impact on the market than many people thought because of drama fatigue. In terms of potential investment opportunities, with improvements in housing, any correction would present a good buying opportunity in the right sectors. However, we'd caution investors in energy and commodities.
Moving forward, if there is a change in the economic picture and additional demand does not materialize, then there could be a real correction-potentially 20-25% and lasting two or four quarters. To be clear, this is not a prediction-just a potentiality.
What is more important to note is that whatever occurs -- downside correction or upside surprise -- the market will move unfettered of excessive intervention meant to manage uncertainty. The market will react to visible risk, to the upside or downside, based upon what is happening. Visible risk, when managed appropriately and intelligently, is also more likely to be rewarded.
So welcome back, visible risk. Your nemesis, complete uncertainty, has faded into the background. We know how to measure, mitigate, and manage risk -- indeed, you've been missed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.