December 14, 2005
Market Storm Brewing?
The Plunging Price of Risk
There’s a major bear market going on, but most investors don’t see it. It's not the stock market, but it's in the stock market. The price of one of the most important commodities has fallen dramatically and it’s having a major impact on your investments. It’s the price of risk. The free market prices risk-taking just like it does everything else—and right now, risk-taking ain’t worth a whole lot.
First, let me back up and explain what I mean. Risk is a funny concept and it confuses many investors (including some pros). When we talk of risk we mean two things: The chance that something will happen, and the consequences of it happening.
Let’s assume there are two companies that are similar in every way. Both are expected to earn $1 a share next year. But Company A is expected to earn $1 a share, plus or minus a penny, and Company B is expected to earn $1 a share, plus or minus 10 cents. Which one will have the higher share price? The market will usually give a premium to Company A. Why? Because the market favors certainty—even if the expected payoff it equal. Amos Tversky said that people don't mind uncertainty so much, but they HATE to lose. As a result, the risk-takers need to be paid.
We can’t see it, feel it or hear it, but risk is ever-present. Risk can be worth untold billions and it’s traded everyday. You use it in nearly economic decision you make. Looking at Companies A and B, the question arises, “how much of a premium should Company A receive?” Well in today’s market, that premium is low.
Here’s another good example. Today, you can buy a one-year Treasury bill with a yield of about 4.30%. If you want a 30-year Treasury bond, you’d get a yield of about 4.64%. Not much difference. The risk-taker—the one sacrificing her money for 29 years longer than the non-risk taker—is only being paid 0.34% a year for her efforts.
If people aren’t paid to take risks, guess what? They don’t take them! The economy has a love/hate relationship with risk-takers. It’s sort of a Prisoner’s Dilemma writ large. Taking risks is what ultimately moves the entire economy along. You can even view the markets as one giant risk-control machine.
Time risk is just one risk, but there are many, many others. That’s another odd thing about risk. We use one word when we’re really referring to many different things. This is another way in which risk confuses us. James Glassman and Kevin Hassett conflated two different types of risks in their book "Dow 36,000," which argued that the market was greatly undervalued. (It wasn't.)
In addition to time risk, bonds also have default risk. But in this bear market for risk, it seems to be hitting the price for all risks. The low price of default risk can be seen by comparing corporate bond yields with government yields. Corporate bonds aren't guaranteed, but government bonds are (the government conveniently controls the printing press). The average spread between corporate AAA bonds and a 10-year Treasury is now less than 100 basis points (or 1%). Not too long ago, it was more than twice that. And after 9/11, the price for risk-taking exploded. The spread reached over 260 basis points. The spread for the riskiest bonds, junk bonds, has widened some this year, but it’s still lower than the historical average.
Then there’s also the VIX (^VIX). The VIX measures the implied volatility of stock prices. This is still risk, but it's yet another kind. We can determine implied volatility by looking at how much option traders are demanding for risk. Right now, the volatility of the stock market is low. Very low. The current VIX reading is below 11, and it’s close to its lowest readings since the rock-bottom days of the mid-90’s. Back in the bubble days, it was common to see the VIX sail over 40.
Stock volatility isn't necessarily tied to other risk prices, like the yield spreads. After all, we had a flat yield curve when the VIX was soaring. But why is everything coming together right now?
Look at how the major stock industry groups are behaving (I’ve talked about this before). Except for energy, the industry groups are acting very much like each other. They're just bunching together. Normally, market sectors show some correlation, but nothing this strong.
In 1999, the beta (a measure of systemic risk) of the S&P 500 Tech Index (^SPLY) was 1.47. In 2000, it was 1.79. This year, it’s 1.06. I don’t think this is a bad thing, and I tend to avoid seeing timing opportunities in this. But it’s a darn curious thing to see. Risk, across the board, is retreating.
I don’t have an answer, but here are a few thoughts. Perhaps the U.S. markets are exporting risk to the emerging economies in exchange for our ballooning trade deficit. Risk tends to follow opportunity. As our economy has become more stable, we don’t have the need for large risk premiums. So we trade it with economies like China. Markets in Latin American have been particularly strong this year. We need their goods, they need our risk.
Then there’s the curious issue of gold. Why is it soaring when inflation doesn’t seem to be upon us? Rates are still low and the dollar is rallying. What’s going on? Gold is a weird one for risk purposes. The price of gold is much more volatile than stock prices. That’s not surprising since it’s a popular vehicle for speculators. But gold is also the least risky asset, in terms of the chance of losing its intrinsic value. Perhaps the rally in gold isn’t a bellwether of inflation, but a reckoning for the risk market.