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Risk-On? Risk-Off? What About Risk-Out?

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Given the significant price appreciation in "risk-off" assets over the past three years, can they still be considered safe?

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Many in the blogosphere have taken this weekend's Barron's cover story, "Don't Lose My Money," to be a bullish indicator. To believe the article, retail investors today value the avoidance of the risk of loss more than they value the prospect of higher returns. (And in that regard, the launch of fellow Minyanville contributors Jay Pestrichelli's and Wayne Ferbert's book Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term would seem to be particularly well-timed.)

In "normal" times I would agree that cover stories suggesting pronounced risk aversion would be a clear buy signal. And in that regard -- and in the interest of full disclosure -- I highlighted my own thoughts on this back in early October 2011 when I posted concurrent The Economist cover, BE AFRAID (subscription required) on the Buzz & Banter. I thought then that "self-assured uncertainty," a key element of what I believe defines a major bottom, was in ample supply.

Today, though, with the HGX up some 60% and the BKX up more than 40%, I am struggling with the validity of the signaling of the Barron's article.

Some of my concern relates to this chart, from the St. Louis Fed, which shows the precipitous decline in personal interest income since 2007. For the American saver, I don't believe the consequences of the drop in interest income can be ignored. As the group that went into this crisis arguably the best equipped to withstand it, they are now being asphyxiated by the one-two punch of the crisis' duration and quantitative easing/financial repression. As I have offered before, for the consumer it is never the depth of the recession that matters, only the length.



But there is a second aspect that currently troubles me. This past Sunday's New York Times had an article by Jeff Sommer in which he offers "Over the last few weeks, 'risk on' trades – embracing stocks…have generally been in favor. At some point, if the 'risk-on, risk-off paradigm' prevails, investors will dump stocks, and bid up safe-haven assets, that for now include Treasury bonds and United States dollars."

A few weeks ago, fellow Minyanville contributor Michael Gayed included a great chart, which I thought captured the ping-pong match between risk-on and risk-off over the past three years, particularly well.



And if you believe Mr. Sommer, what he is suggesting is that the bouncing risk ping-pong ball will merely head the other direction back over the net to the "risk-off" side.

My challenge with that, at least right now, is that the ping-pong game seems to ignore the fact that over the past three years, the "risk-off" trade has resulted in higher and higher prices for "risk-off" assets every time the ball has moved back across to that side of the net. Just take a look at the 10-year US Treasury, or stocks like McDonald's (MCD) and IBM (IBM) for example, and you'll quickly see what I mean.

My concern is that the "risk-on/risk-off" trade is approaching a point where it either has or will soon become a "risk-on/risk-on" trade in which supposed safe havens have become so bid up in price that their risk-free (or at least their less-risk) status is in serious jeopardy.

I realize that the whole notion of safe havens being overpriced must strike some readers as odd, but the more I look at the world, the more I am afraid that that is what the one-two punch of this crisis' duration and quantitative easing/financial repression may have resulted in. Recurring incidents of fear over a prolonged period of time have turned safe into unsafe.

What Barron's suggests is that this ping-pong game should soon end with the ball staying on the "risk-off" side of the table for a prolonged period of time. What I think both Barron's and Mr. Sommer are missing is the potential not for "risk-on" or "risk-off," but simply "risk-out." Having found that safe is no longer safe, retail investors simply opt out altogether.

Early on in the European sovereign debt crisis, Morgan Stanley suggested that that was becoming the case with regards to weakening peripheral country sovereign debt. Once it no longer behaved like the "safe asset" fixed income investors thought it was (and constructed portfolios around), investors exited the asset class altogether.

Needless to say, that has had profound implications for the sovereigns involved as they have become, as Morgan Stanley put it, debt issuers in search of a new investor base.

Time will tell whether that will become the case for the issuers of "risk-off" (supposedly safe) debt and equities. But the longer this crisis goes on, and the narrower and more highly priced the list of safe-haven choices becomes, the more likely I am afraid that may be.

Again, time will tell. But before presuming that the opposite of "risk-off" is simply "risk-on," I think investors would be wise to consider the potential for the ping-pong ball to hit the net and simply roll to the floor in a "risk-out" scenario.


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