The Globe and Mail, Report on Business
Published February 23, 2007
I’ve always encouraged investing enthusiasts to read more than just the newspaper for ideas and education (User’s Guide to the Business Media). If you discover a professional manager on the front lines who writes readable stuff, it’s a great find.
An example of this would be Bill Gross, the widely-proclaimed bond king and voice of Pimco, who publishes a monthly missive on-line. Another would be Jeremy Grantham of Boston-based GMO, whose quarterly piece is always interesting and thought provoking.
As I’ve been reading some of the year-end commentaries and talking to money managers directly, I’ve picked up a subtle change in their tone. It relates to how the market is pricing risk.
Before I get into the change, however, I should point out that there is a broad consensus that risk measures are extremely low right now. In simple terms this means there is an insatiable thirst for higher-yielding, riskier assets. Market players are willing to take on more risk with very little compensation in return.
Yield spreads on emerging market or corporate bonds are at the low end of their range. In the equity markets, there is no consensus on whether price-earnings ratios are high or low, but most managers would acknowledge that the valuation differential between good and bad companies is too narrow, which is another form of risk measurement.
There is other evidence that risk premiums are at a low ebb. Last Friday Harry Kosa talked about the hedge funds’ heroin - the Japanese carry trade. Managers continue to fearlessly pile into this strategy. And the measures that predict future volatility in the bond or stock markets are at the low end of their range.
The importance of all this, of course, is that if our Goldilocks economy – not too hot, not too cold – fails to hold together, there is nowhere for these risk measures to go but up. That will result in lower prices for risky assets, whether it be stocks, bonds, currencies or derivative strategies.
What I found most interesting with the latest round of reports, however, is that many of the whistle blowers are backing off from their fervent stance. They’re still highlighting their concern about the wanton risk taking, but they are also providing reasons why Goldilocks may continue down her blissful path and risk premiums could stay low for a while longer.
Mr. Grantham of GMO says “Goldilocks global conditions, especially cheap and easy credit, have caused the broadest over-pricing of financial assets – equities, real estate, and fixed income – ever recorded.” A few paragraphs later, however, he points out that “just because risk taking is off the charts does not mean it can’t keep going up for another year.” He isn’t yet seeing any cracks in the economic structure and it may take time for a serious unraveling.
One of my hedge fund manager friends took me through a similar scenario last week. He rhymed off all his concerns, but concluded that the good times could continue for a while. Therefore his portfolios weren’t fully committed to the scary scenario. He was hedging his bets.
In his February outlook, Mr. Gross of Pimco says “[asset] prices are increasingly being determined by value insensitive flows and speculative leverage as opposed to fundamentals.” He is referring specifically to the global savings glut (that is funding the U.S. trade deficit) and the extreme levels of corporate profitability, both of which are funneling trillions of dollars into U.S. financial assets. He suspects that this cash flow brew is running out, but concludes that it’s hard to pinpoint when “because of our financially-oriented casino offering innovation after innovation.”
I think the guarded approach these three are taking is interesting because it may represent complacency creeping into the market. I don’t mean to say these managers specifically are complacent, but their current stance may reflect a broader apathy.
When trends go on for a long time, a number of things happen. Investment managers that are too early on betting against the trend start to get beaten up. Their intelligence is questioned and clients may start pulling their money out.
The longer a trend goes on, the more normal is starts to feel. We start to hear why “it will be different this time.” In the current circumstance, lower risk premiums are being justified by globalization and increased financial sophistication.
And the longer and more extreme a trend is, the more likely it will end badly and take longer to resolve than anybody predicts.
Do I blame money managers for being guarded in their words and strategies around the current market situation? Not for a minute. They have a business to run and after all, it’s impossible to predict when a trend is going to end. Certainly, the housing and oil cycles have gone on far longer than I expected.
What we do know for certain, however, is that we have one more necessary ingredient for an eventual trend change. Experts have stopped predicting when the thirst for risky assets is going to end.