The Meaning of Risk: A Proprietary Index for Current Times

"Take the course opposite to custom and you will almost always do well." - Jean Jacques Rousseau (1712 - 1778)

Not known as an investor, Rousseau (philosopher, writer, composer, much slandered, and let us not forget, noted philanderer) was more a keen student of human nature. I refer to his well-known quote here to remind us that risk taking and contrarianism are not new phenomena.

Human nature is something an investor should take time to study, as what are markets but a collection of people buying and selling? There is really only one question an investor is attempting to answer: will the market go up, or will the market go down? Think back to the nature of crowds for a moment. Over the years we have come to the conclusion that there are only two phases of world financial markets - risk seeking and risk adverse. Unsurprisingly, in a risk seeking phase prices tend to rise, in a risk adverse phase, prices tend to fall.

Over the years one of the tools we have developed is a proprietary risk index. It is constructed from a weighted mix of risk grade debt and high yield currencies. What makes our proprietary global risk index different from other gauges of risk, such as the Bloomberg Financial Conditions Index is that it is a trending rather than a “mean” reverting index.

We've included our latest graph below. Quite clearly it's been going strongly in one way. Taking a lead from this, we would say that risk seeking assets (equities, junk bonds, high yield currencies) will continue their recent trend and that their prices will rise. For us, it is interesting to note that over the last few week while the S&P fell, the index continued its upwards path.

Of course we have no real idea how long this risk seeking mood of the crowd will last. Happily, our profits are continuing to rise.

For those interested, Rousseau, a contemporary of Voltaire, Robespierre, and Diderot led a fascinating life. His ideas and writings had effects upon both the French and American revolutions. On your next visit to Paris you may like to see where he now rests, opposite Voltaire, in the crypt of the Pantheon in Paris (Metro: Cardinal Lemoine). Some years ago I took a bottle of Grand Vin Chateau Latour and had quiet toast to some private heroes.

Disclosure: Long JNK, PCY, DBV, CEW.

Comments

[yada yada:]

i think that in the current environment, the concept of "risk" requires a complete re-definition that takes into account the fact that currency, the "asset" that "risk" is conventionally baselined against with a nominal risk of zero, is no longer being seen or treated as such.

in the current global economic environment, fiat currency has become just another asset, and the value of currency itself is clearly "at risk" and being treated by many as a potentially risky asset.

in the past, you could talk about the purchase of equities as a "risk-taking" activity. implicit in that description is the idea that leaving capital in currency/cash was the "risk-free" alternative to the more risky purchase of equities. and all kinds of measures of risk and strategies to mitigate risk have evolved, all based on the implicit or explicit assumption that cash has a risk of zero.

i don't know about you, but i am currently just as concerned about my cash position as i am about any of my equity, commodity, or real estate investments. to me, the cash feels every bit as risky as the equity investments. i doubt that i am alone in this, and i think that a lot of recent divergences in correlations that have held over time is at least partly due to this phenomenon of risk being re-defined, whether explicitly or implicitly.

Sep 29 09:36 AM

[tinscale:]

Good observation and expression of what I've been feeling. Cash is risky but everything else is more so at the moment.

On Sep 29 09:36 AM yada yada wrote:

> i think that in the current environment, the concept of "risk" requires
> a complete re-definition that takes into account the fact that currency,
> the "asset" that "risk" is conventionally baselined against with
> a nominal risk of zero, is no longer being seen or treated as such.
>
>
> in the current global economic environment, fiat currency has become
> just another asset, and the value of currency itself is clearly "at
> risk" and being treated by many as a potentially risky asset.
>
> in the past, you could talk about the purchase of equities as a "risk-taking"
> activity. implicit in that description is the idea that leaving capital
> in currency/cash was the "risk-free" alternative to the more risky
> purchase of equities. and all kinds of measures of risk and strategies
> to mitigate risk have evolved, all based on the implicit or explicit
> assumption that cash has a risk of zero.
>
> i don't know about you, but i am currently just as concerned about
> my cash position as i am about any of my equity, commodity, or real
> estate investments. to me, the cash feels every bit as risky as the
> equity investments. i doubt that i am alone in this, and i think
> that a lot of recent divergences in correlations that have held over
> time is at least partly due to this phenomenon of risk being re-defined,
> whether explicitly or implicitly.

Sep 29 10:01 AM

[chap08:]

I agree. But if you think cash is risky, how about Tbonds?


On Sep 29 09:36 AM yada yada wrote:

> i think that in the current environment, the concept of "risk" requires
> a complete re-definition that takes into account the fact that currency,
> the "asset" that "risk" is conventionally baselined against with
> a nominal risk of zero, is no longer being seen or treated as such.
>
>
> in the current global economic environment, fiat currency has become
> just another asset, and the value of currency itself is clearly "at
> risk" and being treated by many as a potentially risky asset.
>
> in the past, you could talk about the purchase of equities as a "risk-taking"
> activity. implicit in that description is the idea that leaving capital
> in currency/cash was the "risk-free" alternative to the more risky
> purchase of equities. and all kinds of measures of risk and strategies
> to mitigate risk have evolved, all based on the implicit or explicit
> assumption that cash has a risk of zero.
>
> i don't know about you, but i am currently just as concerned about
> my cash position as i am about any of my equity, commodity, or real
> estate investments. to me, the cash feels every bit as risky as the
> equity investments. i doubt that i am alone in this, and i think
> that a lot of recent divergences in correlations that have held over
> time is at least partly due to this phenomenon of risk being re-defined,
> whether explicitly or implicitly.

Sep 29 10:33 AM

[yada yada:]

On Sep 29 10:33 AM chap08 wrote:

> I agree. But if you think cash is risky, how about Tbonds?

to me, no difference between Tbonds and cash in terms of risk. the ultimate cash risk is a government default, which seems inevitable to me, though i can't say whether that is this month or 10 years down the road. if i could, it would feel a lot less risky...

see also this interview with marc faber: seekingalpha.com/artic...

Sep 29 11:43 AM

[chap08:]

yada yada, the difference is that during rising inflation (let alone the hyperinflation that Faber predicts) cash would only lose in real terms. TBonds, on the other hand, would lose in nominal terms too. Inflation means rising yields which means falling bond prices. Currently TBonds are priced for low inflation.


On Sep 29 11:43 AM yada yada wrote:

> On Sep 29 10:33 AM chap08 wrote:

Sep 29 01:02 PM

[Thomas MacLeod:]

did we refer to banks in our article? Don't think so


On Sep 29 04:26 PM DIAMANTE wrote:

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Sep 29 06:15 PM

[Thomas MacLeod:]

how t bonds have held up over the last 5 months is beyond us as well


On Sep 29 11:43 AM yada yada wrote:

> On Sep 29 10:33 AM chap08 wrote:

Sep 29 06:17 PM

[Thomas MacLeod:]

oh yea.. brain dead spammers in full effect today.


On Sep 29 07:17 PM 1st FRONT wrote:

> FDIC keep their Bank Watchlist secret from the public and there is
> a reason to it because many US banks are already bankrupt and FDIC
> can't guarantee deposits anymore.
> We made this list free to all the public, take a look if your bank
> is on our Bank Run list too.
> tinyurl.com/y87d3xw

Sep 29 09:39 PM

[David Van K...:]

Cash has ALWAYS been risky, because inflation has (almost) always been eroding its purchasing power. Today is no different. Cash has always been "risk-free" only in a nominal sense, not in a real sense. The difference today may be the slippage of US$ vs. other currencies, but these have been slipping back and forth for decades. Sometimes it hurts, other times it helps.

Sep 30 10:10 AM

[realold:]

Why does inflation mean rising yields? Because people would prefer to own nothing (cash) or because they would prefer to own commodities (gold)? - instead of bonds. I doubt that inflation = higher yields is a natural law. It seems to me that yields should be higher now but are not because of manipulaiton by the Fed. Maybe you should justify this conclusion.


On Sep 29 01:02 PM chap08 wrote:

> yada yada, the difference is that during rising inflation (let alone
> the hyperinflation that Faber predicts) cash would only lose in real
> terms. TBonds, on the other hand, would lose in nominal terms too.
> Inflation means rising yields which means falling bond prices. Currently
> TBonds are priced for low inflation.

Sep 30 11:40 PM