10 Notes on Risk in the Markets

1) Credit cycles tend to persist for more than just one year. That is one reason why I am skeptical of the run in the high yield corporate bond market at present. Sharp short moves are very unusual. To use 2001-2003 as an example, we got faked out twice before the final rally commenced. So, as I look at record high defaults after a significant rally, I am left uneasy. Yes, defaults have been less than predicted, but defaults tend to persist for at least two years, and current yields for junk don’t reflect a second year of losses in my opinion. S&P is still bearish on default rates. I don’t know if I am that bearish, but I would expect at least one back-up in junk yields before this cycle ends.

2) Of course, there are bank loans in the same predicament. Most bank loans are not listed as trading assets, so they get marked at par (full value) unless a default occurs. Along with Commercial Real Estate loans, this remains an area of weakness for commercial banks.

3) Where should your asset allocation be? Value Line is more bearish than at any time I can remember — though the last time they were more bearish was October 2000. Good timing, that.

David Rosenberg favors high quality bonds over stocks in this environment, which is notable given the low yields. For that bet to work out, deflation must persist.

One reason this still feels like a bear market is that there are still articles encouraging a lesser allocation to stocks. Though one person disses the traditional 60/40 stocks/bonds mix, in an environment where complex asset allocations are getting punished, I find it to be quite reasonable.

4) Maybe demographics are another way to consider the market. When there are more savers/investors vs. spenders, equity markets do better. I’ve seen this analysis done in other forms. So we buy Japan? I’m not ready for that yet.

5) Illiquid assets require a premium return. After the infallibility of the Harvard/Yale model, that rule is on display. As their universities began to rely on their returns, even though there was little cash flowing from the investments, they did not realize that there would be bear markets. Harvard and Yale may indeed have gotten a premium return versus equities. It’s hard to say, the track record is so short. One thing for certain, they did not understand the need for liquidity; a severe present scenario has revealed that need. As such, investors in alternative investments are looking for more liquidity and transparency.

6) There are limits to arbitrage. As an example, consider long swap rates. 30-year swap yields should not be less than Treasury yields — they are more risky, but do do the arbitrage, one would need a very strong balance sheet, with an ability to hold the trade for a few decades.

7) One thing that makes me skeptical about the present market is the lack of deployment of free cash flow in dividends or buybacks. When managements are confident, we see that; managements are not yet confident.

8) I would be wary of buying into a distressed debt fund. Yields have come down considerable on distressed debt, and I think there will be better opportunities later.

9) It seems that the US Dollar, with its cheap source of funds for high quality borrowers, is attracting some degree of interest for borrowing in US Dollars in order to invest in other higher yielding currencies. I’m not sure how long that will last, but many see the combination of a low interest rate and a potentially deteriorating currency as attractive to borrow in.

10) The difference between an investor and a gambler is that an investor bears risk existing in the economic system in order to earn a return, whereas the gambler adds risk to the economic system that would not have existed, aside from his behavior.

Comments

[markfl:]

David Merkel wrote:
"It seems that the US Dollar, with its cheap source of funds for high quality borrowers, is attracting some degree of interest for borrowing in US Dollars in order to invest in other higher yielding currencies." Indicative of greater risk appetite and possibly due to carry trades ($ instead of Yen)?

Sep 13 01:23 PM

[Gtarras:]

Bahrain Con, nice try, your name says it all. LOL!


On Sep 13 03:51 PM BAHRAIN CONNECTED wrote:

> SECRET THAT YOU WILL NEVER KNOW EVEN IF YOU DIE FOR IT (chart in
> instablog)
>
> All of you know what is VIX ( S&P 500 1 month expected volatility
> ) but none of you knows what was the VIX high in the last 100 years.
> This chart shows VIX during last decade that included Asian crisis,
> Russian debt default, South America crisis, Turkish Lira devaluation,
> Nasdaq bubble, September 11, 2001 and even 2008 market panic. Now,
> before I will tell you the secret, I ask you to take your time, do
> your own research and write on my website in the message or chat,
> what is the highest number you came upon. You can even count from
> 1929 if you want (this requires different matrice calculation, but
> 1929 didn't had the higher VIX what you can see from this chart,
> because VIX is derived from ATR average true range, which was no
> bigger than during other stock market crashes).
> Only few people know what was the highest historical VIX, I am one
> of them.
> From this chart the important levels are 21.17, 13.09, 54.87 and
> 90.06.
> Most institutional investors traded by this levels and bought stocks
> when DJIA was 6600 and VIX aroud 90, for the wrong reason and they
> are going to lose everything. I will share this secret only with
> traders who will submit their high VIX variation on my website. Good
> luck, split timing started.
>

Sep 13 04:48 PM

[Deepv:]

The difference between an investor and a gambler is that an investor bears risk existing in the economic system in order to earn a return, whereas the gambler adds risk to the economic system that would not have existed, aside from his behavior.
---

No. An investor is someone who agrees to *defer consumption* to see it grow over the LONG TERM as a BUSINESS OWNER in value creating enterprrises.

A gambler is someone who sees the market as a big casino and companies only as "stocks" to "play" and move in and out of.

There are many ways to skin a cat, but if you are gambler you better know what game you are playing in the casino.

Sep 13 07:05 PM

[Terence Chow:]

Unfortunately most of the links require annual subscriptions.
Good article nonetheless. Thanks.

Sep 13 08:49 PM

[sethmcs:]

I am of the opinion that since the GM debacle that corporate debt is more risky and at current yields is not worth the risk. I prefer tax qualified dividends which offer a better rate of return. I loaded up on cheap dividend stocks last quarter. Thats not to say that I will not buy distressed debt (gambler talking). The rate of return on distressed debt is high. Here is an example. Ford common stock from low of 1.01 to recent high of 8.86 returned 777%. Ford Convertable Preferred which acts more like a bond than a stock went from a low of 3.00 to a recent high of 31.48 949% move. One of the consequences of the debt crisis is that debt is more risky than equity. Or so it seems.

Sep 14 12:49 AM

[Moon Kil Woong:]

I agree with you sethmcs. In fact long term debt not only has default risk but very real inflation risk. That's why a flood of money has moved from long Term US Treasuries right into the stock market. However, as equity prices rise the risk for a terrible loss in equity from a sell off raises the risk to balance things out. The fact that equities are moving up on money flows and dollar weakness is distrurbing because these things are not of intrinsic value and are not fundamental.

Not only can such things change directions, they can do so astonishingly fast. Although I'm not a goldbug I certainly can understand such bunker mentality.

Sep 14 02:32 AM

[Jeff Diercks:]

I agree that risk is everywhere in this market from corporate debt to equities. Normal inter-market relationships are not working because of the nature of this ongoing crisis and the universal confusion many investors face today.

Therefore, may I suggest the only safe way to play in this market today is as a speculator....not an investor. May I further suggest that trend following and technical trading are the way to go for the near term.

Sep 14 08:28 AM

[tripleblack:]

Yes, this jumped off the page for me, too. I think this is already starting to occur. I would not be surprised to see TARP funds used for this purpose either.


On Sep 13 01:23 PM markfl wrote:

> David Merkel wrote:
> "It seems that the US Dollar, with its cheap source of funds for
> high quality borrowers, is attracting some degree of interest for
> borrowing in US Dollars in order to invest in other higher yielding
> currencies." Indicative of greater risk appetite and possibly due
> to carry trades ($ instead of Yen)?

Sep 14 08:47 AM

[Emerald:]

And we pay CEO's of large banks to invest our government suppied equity in government bonds? Cap pay and bonuses on this activity as a percentage of the bank's annual cash flow. Max pay of $100,000 for buying Treasuries. This is the real TARP arbitrage that is ripping us off!

Sep 14 10:12 AM

[Burton A. J...:]

Tell the mathematicians to go home.

All the math you need in investing is basic arithmetic, a little algebra, and a computer than can figure compounded return.

Risk, as defined by Warren Buffett, is the possibility of a complete loss of capital. I've yet to see risk better defined. Risk is not price volatility.

Every dervitave that is added to an investment portfolio only serves to magnify and diffuse risk of loss.

Nobody needs a Nobel Prize to invest successfully.

Burton A. Johnson, MD, JD
President
Burton A. Johnson Portfolio Management, Inc.
bajvalueinvesting.com

Sep 14 12:45 PM

[MBAmichael:]

Entrepreneurs need to invest in themselves first and position themselves for the opportunities that under achievers & gamblers will create over the next couple of years. All CEOs in bed with the government or with their hand out for a bailout should be removed. Until we see an end to the corruption that exists between Wall Street and government, the average investor isn't going to have much faith in corporate earnings. Risky behavior is rewarded these days with bailouts and bonuses.

Sep 14 04:49 PM

[Plant the s...:]

I think this is happening at the corporate level already per some of my friends in Investment Banking


On Sep 13 01:23 PM markfl wrote:

> David Merkel wrote:
> "It seems that the US Dollar, with its cheap source of funds for
> high quality borrowers, is attracting some degree of interest for
> borrowing in US Dollars in order to invest in other higher yielding
> currencies." Indicative of greater risk appetite and possibly due
> to carry trades ($ instead of Yen)?

Sep 14 05:57 PM

[Cash999:]

If the term investor is replaced by speculator, the description makes sense. A speculator assumes risk that already exists, whereas a gambler creates risk when he places a bet on the blackjack table.


On Sep 13 07:05 PM Deepv wrote:

> The difference between an investor and a gambler is that an investor
> bears risk existing in the economic system in order to earn a return,
> whereas the gambler adds risk to the economic system that would not
> have existed, aside from his behavior.
> ---
>
> No. An investor is someone who agrees to *defer consumption* to
> see it grow over the LONG TERM as a BUSINESS OWNER in value creating
> enterprrises.
>
> A gambler is someone who sees the market as a big casino and companies
> only as "stocks" to "play" and move in and out of.
>
> There are many ways to skin a cat, but if you are gambler you better
> know what game you are playing in the casino.

Sep 14 08:01 PM

[Cash999:]

If the term investor is replaced with speculator, this statement makes sense. A speculator assumes risk that already exists whereas no risk exists until a gambler places a bet on the Blackjack table.


On Sep 13 07:05 PM Deepv wrote:

> The difference between an investor and a gambler is that an investor
> bears risk existing in the economic system in order to earn a return,
> whereas the gambler adds risk to the economic system that would not
> have existed, aside from his behavior.
> ---
>
> No. An investor is someone who agrees to *defer consumption* to
> see it grow over the LONG TERM as a BUSINESS OWNER in value creating
> enterprrises.
>
> A gambler is someone who sees the market as a big casino and companies
> only as "stocks" to "play" and move in and out of.
>
> There are many ways to skin a cat, but if you are gambler you better
> know what game you are playing in the casino.

Sep 14 08:09 PM

[Douglas T:]

MBAmichael: Totally agree with your statements, couldn't have said it better. www.mutualfundwealth.com/


On Sep 14 04:49 PM MBAmichael wrote:

> Entrepreneurs need to invest in themselves first and position themselves
> for the opportunities that under achievers & gamblers will create
> over the next couple of years. All CEOs in bed with the government
> or with their hand out for a bailout should be removed. Until we
> see an end to the corruption that exists between Wall Street and
> government, the average investor isn't going to have much faith in
> corporate earnings. Risky behavior is rewarded these days with bailouts
> and bonuses.

Sep 15 06:08 PM