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Thoughts on the Risks of Being a Bull or a Bear

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Minyanville contributors Peter Atwater and Michael A. Gayed, CFA, provide perspective on the most important issue when it comes to portfolio management.

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Risk comes from not knowing what you're doing.
-- Warren Buffett

Traditional finance focuses on two main source of risks when it comes to stock market investing. The first is one stock pickers are all too familiar with, which relates to the risk associated with the specific company invested in. In finance talk, this is called "idiosyncratic" risk because it is specific to the stock as opposed to the entire stock market. One example of this is the multiple changes in corporate strategy the executives of Netflix (NFLX) took last year, causing some massive swings and ultimately heavy losses for many who bought at the top.

The nice thing about idiosyncratic risk is that it can be diversified away within a portfolio. In other words, while Netflix had its own company-specific problems, General Electric (GE) and IBM (IBM) performed well for the year. Averaging your money across these three stocks would have resulted in overall losses that were less than had you owned Netflix alone. The more stocks, the more diversified, and the less an individual stock can determine the ultimate fate of your portfolio. This leads into the second main type of risk that traditional finance focuses on, called "systematic," or market risk.

By definition, a diversified portfolio can result in the idiosyncratic risk being mostly avoidable through averaging. Market/systematic risk, however, can not be diversified away. This is because beta is ultimately an average of the common risk factors that unite stocks. Beta can be measured with some fancy formulas to give one a sense of how sensitive a stock is historically to the market risk that is ever-present.

Investors in the stock market like high beta stocks in a diversified portfolio when there is a bull market, since it means the average of that portfolio of stocks is "generally" more sensitive to overall macro movement in the asset class. If you're forced to be in equities and you're headed for a bear market, investors likely would favor lower beta stocks that are less sensitive to a declining environment "generally." The word "generally" is purposeful here because there are times when lower beta stocks can actually decline and diverge from broader stock market averages regardless of whether it's a bullish or bearish environment. We will revisit this later.

So we know about idiosyncratic risk and systematic risk, i.e., company-specific and market/beta risk. There is, however, another risk that is not addressed in traditional finance. This is a risk that does not show up on any kind of brokerage statement and is only ultimately known with hindsight.

In 2011, it turned out for S&P 500 (SPY) buy and hold investors that risk was minimal given that performance was flat by year-end. However, a huge opportunity cost existed for investors who could have put money to work in long-duration Treasuries (TLT) as yields dropped and bonds had their best year of performance in a long time. Being in equities that did not lose money resulted in opportunity cost risk by missing the move in bonds. And from a compounding perspective, that's a huge thing longer term.

But again, this is something we only truly know with hindsight. However, if markets go through cycles, and sectors/asset classes continuously move through time in phases of out/underperformance, leading and lagging, then perhaps one can try to actively minimize opportunity cost risk. This is why it is particularly important for investors to not just look at an absolute price chart, but to consider intermarket trends to identify where persistence of leadership is occurring, and to get a sense of what the market's conscious or subconscious message is through relative price movement.

Note that when dealing with opportunity cost risk, one has to think in relative terms. A sector or asset class can "lead" by simply being down less than the alternative. With that said, let's go back to the very important distinction between relative and absolute risk, by using defensive stocks that tend to be income-oriented as an example historically.

Since the market bottom in 2009, there has been a consistent reluctance among investors, particularly retail investors, to re-embrace growth stocks, which they continue to perceive as risky. During 2011, this became even more pronounced as investors sought out dividend "aristocrats," companies with long-standing track records of paying out dividends to investors. The result was significant outperformance by companies that, in other time periods, would have been considered old and boring.

Last year was a great example of that as volatility swelled and investors fled to Treasuries and anything dividend oriented. One way of seeing this visually is by looking at the price ratio of the SPDR S&P Dividend Index ETF (SDY) relative to the S&P 500. As a reminder, a rising price ratio means the numerator/SDY is outperforming (up more/down less) the denominator/SPY. The trend as marked shows persistence in preferences investors have for stocks that are defined by dividends and stocks that are defined by capital appreciation.



From a historical perspective, 2011 closely resembles the "Nifty-Fifty" bubble of the early 1970s, when investors then focused their attention and investment dollars on a very narrow group of the country's most successful multinational corporations. As the Nifty-Fifty bubble occurred within the context of a much longer bear market period, the question arises of whether history is rhyming once again with investors reacting to their own fears and inadvertently (and ironically) contributing to a bubble in those assets they believe to be the safest.

Yes – bubbles can occur in "risk-free" assets as well. This once again relates to the core purpose of this writing of how one should think about risk.

Needless to say, the after effects could be equally punishing, with the highest quality assets underperforming lower quality assets in a downturn. Could that happen? Certainly, the concurrent flight to quality trade that we saw in 2011 into US Treasuries out of European sovereign debt and into gold (GLD) out of "fiat currencies" suggests that that risk should not be discounted, but it also suggests that in their pursuit of "relatively" less risk, investors have potentially generated greater "absolute" risk.

For most investors there is a general acceptance that higher relative risk regularly brings with it the potential for higher absolute risk, particularly when a trade becomes crowded. But the idea that a lower relative risk strategy could bring the potential for higher absolute risk would seem to run counter to conventional logic. But that may be just one of the major risk consequences of the deepest and most prolonged downturn in mood since the 1960s.

Another risk that investors may want to consider is that frustratingly slow economic recovery since 2009 has led to greater and greater extreme forms of financial repression. For many investors, it is neither a bull nor a bear market, but rather a bullied market. Rather than being truly committed to their specific investments, many investors have merely concluded that they have no choice but to be compliant with what has become more and more overt and extreme coercive policy actions. As true market strength is more a measurement of confidence and commitment than compliance, our current market may also reflect this kind of risk.

So long as coerced investors remain compliant, there is little downside risk. The problem arises, though, when these coerced investors begin to doubt the willingness or ability of policymakers to act or the effectiveness of policymakers' actions. During the fall of 2011, the market got a taste of that risk when confidence in policymakers was shaken, with The Economist even going so far as to offer a cover near the market bottom, suggesting to "be afraid."

While the European Central Bank's oversize long-term refinancing operation (LTRO) would appear to have been in response to investors' broad questioning of policymakers' willingness and ability, there is little to suggest that the market's confidence in global policymakers has been permanently restored.

To sum up, addressing the question of risk is much more nuanced than traditional finance textbooks would have us believe, and we seem to be in an environment where absolute, relative, and policymaker risk is more heightened than at any time before in history. Thinking about stop losses to minimize the "risk of loss" is not enough. For investors, the post-banking crisis market has required investors to not just maintain a focus on the traditional concerns of relative and systemic risks, but also to consider the consequences of social mood and confidence in global policymakers.

Michael Gayed's Twitter: @pensionpartners
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