Visions of Sugarplums
At risk is the neophyte investor going along for the ride....
"As 2005 winds down, the clock is ticking on all the long-risk strategies frantically exploited to turn this lackluster year into something decent. This week we offer our Top 3 candidates to be unwound in 2006---if not before."
"It is all about pricing risk, which is far from rational. The biggest driver of asset prices is risk premium. This is miscalculated from 1) the inherent inability of people to understand it; they skew the probabilities and 2) greatly exacerbated by the system we operate under. You indirectly refer to it and I call it the "other people's money" syndrome. Hedge funds, mutual funds, pension funds, etc. operate to maximize their own returns. This causes too much risk to be taken."
"Your conclusions are correct. The only thing we don't know is how long it goes on before we get a "re-pricing" of risk. There need not be a cause: markets at some point will just "snap"."
The first lines are the concluding remarks of one of the best macro minds in the business (our opinion) and the second is my response.
The paper my friend is arguing from shows credit spreads widening and stocks caring little (I point out that these are only coincidentally correlated, but as a favorite indicator of Brian Reynolds, we must point out that they have widened and that widening is understated as many bonds are removed quickly from the sector and placed into the junk category. The relative size of junk bonds to other corporate bonds has tripled if not more over the recent years). It shows the housing industry rolling over and gold/oil/bond volatility picking up as equity volatility continues to decline.
My friend points out what I have: that our economy is now asset-based, that almost all growth is driven by speculation and that depends on ever rising nominal asset prices. Central banks know that so they have "bent over backwards" to keep them rising.
So why are markets so stubborn about mis-pricing risk? Her main tenet is what we have talked about many times: OPM, or "other people's money," syndrome. In an effort to generate returns, a matter of survival, hedge funds, mutual funds, pension funds, etc. have taken on ever increasing risk to generate those returns. They are buying stocks that are the most heavily shorted (for good reason) in order to try to squeeze the shorts out into year end, they have been shorting yen to buy dollars to "earn" the differential in interest rates (only to be squashed the last few days). They have been buying the best performers like financials and housing stocks in the face of deteriorating fundamentals.
As year end approaches, the angst of the OPM crowd grows and so does their hubris. At risk is the neophyte investor going along for the ride with visions of sugar plums dancing in their heads. For funds like mine, we slowly enter trades contrary to this momentum; as we do it we control risk in case the momentum continues.
That is all I can do for my investors: put on good risk/reward trades at the expense of mis-estimated risk premiums carried in the markets.
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