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How Did We Get Into This Mess? Part 2


2009 could be a grim year.


Editor's note: This is the second part of a two-part series. The first part can be found here.

"History has not dealt kindly with the aftermath of protracted periods of low risk premiums."
- Alan Greenspan (August 27, 2006)

My reaction to Greenspan's quote is "Amen." In the first part of this series, I focused on the extreme money growth has taken place since 1995. The result of the money supply growth was a stock market bubble and subsequent burst, followed by a real estate bubble that is in the middle of a bust and a bubble of complacency. When I say a bubble of complacency, I'm referring to the extremely low level of returns investors were willing to accept for taking risk. As Greenspan and company helped create the bubbles, I find it ironic that the above quotation came from him.

What Do Low Risk Premiums Look Like?

Risk Premium is defined by Bloomberg as "the amount above the risk-free rate that investors seek before they will put money into a risky asset." In periods of protracted complacency, the aftermath is indeed unpleasant. I would compare it to someone getting over-served at a party and the hangover that follows. The longer the party, the longer the hangover.

At my firm, Atlantic Advisors, we track investors' appetite for risk in both stocks and credit. Complacency in credit is observable as low spreads between the yields of U.S. Treasury securities and corporate credits. I like to track the Bloomberg 'B' rated Industrial Index versus Treasury yields as a proxy for willingness to take risk. My firm also reviews spreads on agency, mortgage and corporate yields on a daily basis.

As these spreads widened from the end of 2007 into the Bear Stearns (BSC) abyss, my firm did take advantage of over-weighting mortgage backed securities. My firm has now lightened positions as spreads have tightened again in favor of cash and two year Treasuries. I expect more spread widening, and will opportunistically add to this sector again as I'm better compensated for risk (risk premium defined).

I expect that year-end 2008 as well as 2009-2010 could provide an opportunity to get positioned as financial entities (everything from banks, brokers and hedge funds) are forced to de-lever.

Spread between Bloomberg 10 Year B rated Industrials versus 10 Year Treasuries

Click to enlarge

Agency, Mortgages and Corporate Yield Spreads (in basis points over Treasuries)

Click to enlarge

Note the low risk premium in 1996, followed by higher risk premium (increased fear) during the Long Term Capital Management fiasco in 1998. Then another spike when stocks began the secular bear market (where we find ourselves currently), again following 9/11, and once more at the bottom of the cyclical bear market in early March 2003. What comes after that, however, is a protracted period of investors accepting rather low premiums for owning 'B' rated bonds (nearly four years of complacency that ended abruptly as the credit crisis began in 2007).

Returning to Greenspan's quote: I believe that the credit crisis is nowhere close to complete. In fact, I believe this crisis will likely drag on for much longer than most expect and that the depth of the crisis will be far worse than most expect. I've been cautious for nearly a decade now and, if anything, I am becoming more cautious than ever.

I'm an absolute return investor that doesn't pay much attention to benchmarks, except the benchmark of "not losing." My basic question is, "What would you buy if there were no benchmark?" The answer that my firm comes up with on a daily basis is "Whatever properly compensates you for the risk." Sometimes, this means taking little or no risk, and while the markets can rally without my participating, avoiding loss is the key to any absolute return approach.

Another way to judge risk is by tracking the VIX Index (the CBOE S&P 500 Volatility Index, which is based on the weighted average of the implied volatilities from front month options). During times of complacency, the VIX generally is low, and as you will see in the chart below, it spikes during times of fear.

Note the four year period from 2003-2007 of subdued risk premium. This was during the period when stocks marched relentlessly higher, credit spreads remained incredibly tight, and Wall Street got the alchemy machine rolling that brought us CLO's, CDO's and the like.

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No positions in stocks mentioned.

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