FLUMMOXED!

June 21st, 2017 | posted in: Investing, Uncategorized

by: William Spitz

In the first quarter of 2017, I wrote a paper called 16 Risks The Stock Market Seems To Be Ignoring. The gist of it was that quantitative measures indicated that investors were not very concerned about risk although there seemed to be plenty of things to worry about.  Well, the situation has become even more extreme.  Measures of expected risk have fallen even further; the volatility indices for US stocks, foreign stocks, bonds, currencies, and gold are about 35% below their long term averages.  Recently, the price of oil has fallen significantly, but even its expected volatility is a little below the long term average.  And, credit spreads on high yield bonds, which measure the fear of default, have dropped about 44 basis points this year and 221 basis points over the past twelve months and are now about 185 basis points below their long term average. The bottom line is that investors perceive the world as a very safe place.

There are actually some pretty solid reasons for this optimism. The world is characterized by easy money and is awash in liquidity.  Central banks are perceived as willing to step in to prevent any serious economic problems.  The economy is growing at a moderate rate with relatively low inflation and corporate profits are very strong.  Finally, bond defaults are very low signaling health in the credit markets.

But, complacency is one of the greatest risks in investing and one measure that I follow suggests that it was only more widespread in 1968 and 1998, both periods of excessive optimism that ended badly. Of the 16 risks I cited in the previous paper, only two have changed. The French election is now over and investors treated the outcome as likely to promote stability.  And corporate capital spending has recently ticked up, although the cumulative effect of low spending over the past five years may impact productivity growth for a while.

 

What do I make of all of this? Frankly, I am somewhat flummoxed although this is certainly not the first time in my investment career.  There are certainly a number of very positive developments in the economy and markets which may well justify the returns that we have enjoyed in the last six months. But, there are also still plenty of risks.  That leads to the big question of the day; is the world really a lot safer as the markets suggest?  Or, are investors really complacent?  Of course, I don’t really know the answer and I may well remain flummoxed for some time.  So, I am left with the following strategy recommendations:

  • Be wary of a simple stock/bond portfolio. Instead, maintain a significant allocation to diversifiers and alternative investments.
  • Only take risk where you are being well compensated, and don’t reach for yield.
  • Hold some dry powder. It may make sense to increase your cash reserve to support a longer period of spending.

The bottom line is that rather than being cavalier as the risk indicators would suggest, we should be extra vigilant and continuously reassess the balance between risk and return in the capital markets.

Tags: