Ten 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 bew 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.