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Reduce your risk in 2006

Thursday 08 December 2005 10:17AM

We are nearing the end of the first year of the Presidential election cycle which, along with year two, is typically when house cleaning gets done, and moral hazard is reduced.  The normal stock market response to this is to struggle, which is exactly what it is doing.  Risky assets typically do particularly badly in these first two years, before doing very well with the stimulus of year three. 
 
Through May this year, risky stocks were underperforming steadily, especially small cap and volatile stocks.  Then, just as we were feeling cocky (since this is what we had predicted and positioned for), there was a vicious rally in everything risky.  This continued the ebb and flow of battle between risk and caution that has been going on for some time now.
 
The record of this third quarter rally in risk was impressive, given that it came on top of the already extreme 2003–04 strength in risky assets. Many risk measures in fact have now reached record levels, resulting in probably the lowest risk premium on average recorded in modern times. Even Mr. Greenspan was shocked and awed.  “History,” he said, “cautions that extended periods of low concern about credit risk have been invariably followed by reversal, with an attendant fall in the prices of risky assets.”  Well it took him awhile, but mean reversion lives! 
 
How embarrassing to finally be on the same side of this argument with the Chairman himself.  Since, in my opinion, he produced most of the fuel for this move and threw it on the fire himself, this expressed concern gets him both the Chutzpah Award for 2005 and his fifth consecutive Career Positioning Award.  When a more normal risk premium returns, its consequences will be borne by his successor. Mr Greenspan can be the elder statesman who warned him (or her) of the risks of a sustained low risk premium. 
 
 
Asset Category          15-Year Peak   Current         15-Year Low
Emerging Debt Spread*        15.5               2.4                          2.4
Junk Bonds Spread*             12.9               3.6                          2.4
Quality Stock Premium**        8.0            -23.0                       -26.0
 
  Definitions: (1) Emerging Country Debt and Junk Bond spreads measured against 10 year U.S. Treasury yields. (2) High quality versus low quality stocks, according to GMO's value model.
 
One of the reasons Greenspan was surprised at the risk-taking rally was of course that he had continued to raise interest rates, despite the New Orleans disaster, to 3.75% and left the world with the impression that two more raises are in the bag for the next few months.  This will leave us for the first time in several years close to a ‘normal’ real return at the short-end of the interest rate curve.
 
An interesting question is why the risk premium is so low and, indeed, why does it move around so much in general and what factors move it?  We have a strong hunch that the predominant input is extrapolation.  That is to say, today’s conditions, whatever they are, are assumed to be permanent.  Today’s much improved financial condition of the emerging countries - for example, in terms of GNP growth and improved reserves, currency strength, local inflation, and lack of financial crisis - is assumed to be a permanent condition, despite a long and painful history to the contrary. 
 
Similarly, with junk bonds and equity quality spreads the difference in profitability between high quality companies and low quality has narrowed materially, as it did back in 1980 in the oil crisis.  If such a narrowing were indeed to be permanent, it would justify the narrowing in P/E differentials and yield spread that has taken place.  It is possible that high quality companies have permanently lost their profitability premium and that the market is right.  It is of course far more likely that this ratio ebbs and flows in a largely unpredictable way and that extrapolating the current point, particularly when it is at an extreme, as it is now, will produce a painfully wrong conclusion.
 
Everyone agrees that there are extreme imbalances in the U.S. and the global economy, in part due to our extreme lack of savings and associated accumulated personal debt, and our extreme trade deficit, now at 6% of GNP.  The bulls believe that all will work out, and certainly so far is so good.  The bears believe that sooner or later these problems will hit. 

Historians have to believe that financial conditions, and confidence at all levels, ebb and flow over time and that we have extremely favourable levels of confidence now, despite potential problems.  The probable winning bet is not to assume an extrapolation, but a very mean reversal.  A shift in the risk premium back to normal levels will dominate the ins and outs of investing, I believe, for the next few years.
 
As always, though, the problem is timing.  What can we say on this topic?  First, the first two years of the Presidential Cycle are typically very risk averse and on average show poor relative equity markets and very poor returns to risky stocks.  Minus 2% real in the first year and minus 4% real in the second year is the average return since 1964 to the riskiest quarter of the market cap, with risk defined as volatility.  (I don’t mean minus 2% and minus 4% relative to the market.  I mean an honest-to-goodness negative absolute return!) 
 
Second value matters in the first two years (unlike year three), and the market is expensive now, with the risky quarter of the market more expensive than the market.  The low quality versus high quality spread, after a very strong return to risk in the third quarter, is now at its lowest point ever, except for a brief period in the recent great 2000 bubble.  Third, Mr Greenspan is retiring and his desire to get out intact may have something to do with the unusual speculative strength this year.  Moral hazard (the "Greenspan put") plays a critical role in the level of speculation, and this last year for him is more like the fourth and last year of a Presidential Cycle when the overwhelming desire is to coast up to the election and not rock the boat.
 
Fourth, short rates are rising and are squeezing the level of comfortable leverage for speculation.  Fifth, profit margins, so critical to sustaining confidence (see our last quarter’s letter), are unsustainably high and exposed to many pressures – oil prices, rising rates, and the increased competition that goes with record margins.  These pressures on profit margins suggest to me that they have probably already peaked and will be revised down later, as they were in 1998 and 1999.
 
This is a long list of problems and leaves me feeling that the period from now to late next fall is very vulnerable to a widening risk premium, with all that portends for equity prices in general and risky assets in particular. Long-term believers in mean reversion like us try to stay in “sooner or later” land, but this long list makes it irresistible to say that the odds of the risk premium widening in the next 12 months are at least 2 to 1 and probably 3 to 1.
 
The current, most accepted definition of risk is that it is volatility.  It is an incomplete definition however, as it ignores value and liquidity. In real life, the probability and extent of loss has directly varied historically with value, or the price you pay, and it is hard, if not impossible, to imagine that this will not continue. 

For example, since 1925 if you bought the S&P when it was in the cheapest 10% by price to trailing 10-year earnings and held it for 10 years, you made an average of 10.6% real per year.  Buying when it was in the most expensive 20% band of experience, you made a measly 0.6% real per annum.  It certainly seems that statistically value had a lot to do with the risk of receiving a disappointing return.
 
The problem with using volatility as a complete measure of risk is exaggerated by the market’s usual tendency to extrapolate present conditions rather than to assume today’s conditions will tend to regress to normal.  Thus, extremely low volatility today is seen as predicting that the market will have low risk into the indefinite future. Today portfolios that at normal volatility would be considered very risky are now considered acceptable.
 
The second important missing ingredient in today’s definition of risk is liquidity.  The market always demands a big risk premium for illiquidity to reflect the extra cost and delay in changing investment positions quickly and cheaply as data changes. In a behavioral world where career risk is important and investors value their ability to stay with the pack, a large liquidity premium exists.  In U.S. stocks, for example, the most illiquid quarter of the market by market capitalization has outperformed the broad market by over 1% a year over at least the last 40 years.
 
From time to time, the market has had liquidity crises in which the need to sell illiquid positions has caused extreme price weakness, which in turn has precipitated more selling.  We now exist in a world of a $1-trillion dollar hedge fund industry (not counting huge leverage) that has risen to at least 25% to 30% of total daily stock trading.  Hedge funds are fairly reliably claimed to be longer less liquid holdings than they are short, since they attempt to benefit from the risk premium.  The Long Term Capital crisis was an example of what can happen as a wave of selling illiquid issues snowballs.
 
As if this were not enough, rising interest rates are also involved.  Low rates justify more leverage, just as low volatility does.  As rates rise, the justifiable level of leverage contracts, and selling of leveraged hedge fund portfolios begins.  An equal reduction of long and short portfolios, if hedge funds are long illiquid issues, will then result in less liquid issues underperforming and may start the turtles running down the beach.
 
High leverage and rising rates, plus rising volatility, combined with a liquidity premium and asymmetrically illiquid hedge fund portfolios is a heady brew, and a dangerous one.  The usual brake on a market decline is value: as stocks and assets decline, they become cheaper and hence more attractive.  In our new world that seemingly ignores value as a risk component, falling assets are more likely to merely become more volatile and hence riskier and less attractive. 
   
I have already heavily committed myself to an anti-market anti-speculation forecast.  Beyond that, the biggest question is: can emerging market equities at least hang in if we have a general increase in the risk premium?  It is probably wishful thinking, but I believe the fundamentals and relative value in emerging markets are so advantageous that they have a 50/50 shot at outperforming the S&P index in anything up to a 10% decline for the index. 

I still believe that if the market surprises me and goes up, emerging equities will bury everything once again. Once again, therefore, but with even more enthusiasm, my message is: reduce risk taking everywhere and do it now.

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