January 26, 2010
The Pricing of Risk
The pricing of risk remains the gravamen of financial markets. Some risks are properly priced for the short term, others for the long term, while other risks are improperly priced. The best way to approach the markets in 2010 is to consider whether markets are pricing different types of risks properly.
Political Stability: Political instability is being severely underpriced by the financial markets. There is little indication that the financial markets are expecting any type of political instability in 2010, either domestically or abroad. Perhaps it is more accurate to say that markets are so focused on the fact that the economy appears to be recovering from its near-death experience in 2008 and early 2009 that it is ignoring political threats. Unfortunately, however, those threats have not disappeared.
Domestically, President Obama and the Democratic Party are facing significant resistance to their economic and foreign policies. The healthcare bill that is being forced down the throats of both Congress and the American people has taken on a life of its own in the minds of its creators but appears to be profoundly flawed. The goal of insuring more Americans is a worthy one, but there are better ways to accomplish it than this bill, which is highly unpopular and was constructed in an unseemly manner that highlighted the worst aspects of our political system. The failed Christmas-day bombing revealed the contrast between the current administration’s soft approach to foreign affairs and the hard line taken by the Bush administration and may have initiated the inevitable reconsideration of our former president’s reputation in that area (his economic reputation is unsalvageable). The unity of the Democratic Party is beginning to show serious signs of erosion, and the 2010 elections could spell the end of the liberal ascendancy.
Abroad, instability is brewing in a number of familiar places. Pakistan, Afghanistan, Yemen and Iran are four places that threaten global stability. The Taliban and Al Qaeda are growing bolder in their attacks both within these countries and around the world. Iran is moving forward with its nuclear plans despite the distractions of growing domestic unrest and remains a potential flash point. It will require extraordinary leadership from the Obama Administration in foreign affairs to steer events in positive directions. In the area of foreign affairs, the President continues to believe that he can use “soft power” to battle stateless Jihadists whose battle plan consists of blowing up soft civilian targets. With the exception of Afghanistan, President Obama has failed to exert American power in a manner that promotes either American interests or the prospects of peace. He should change course immediately by reversing his decision to close the prison camp at Guantanamo Bay. It takes a wise leader to understand that the types of enemies we are facing today understand strength, not weakness.
HCM cannot recall a time at which this country cried out more loudly for national leadership, and when that cry was greeted with more resounding silence. President Obama is spending his authority and political capital in too many directions; the result is that he is becoming diminished in stature and power. This has allowed Congress to step into the vacuum created by an over-committed president, and the legislation being written in Congress is wreaking havoc with the future of America. The President should use his upcoming State of the Union Address to take back the agenda from Congress and reassert his leadership. Failure to do so will could seriously hamper the rest of his term and make a second term an uncertain proposition.
Volatility: Stock market volatility is also being underpriced. The Chicago Board Options Exchange Volatility Index, popularly known as the VIX index, measures the implied volatility of S&P 500 index options and is currently trading at extremely low levels, implying that the market is expecting relatively smooth sailing in the months ahead.
Graph 1 below shows the recovery in the VIX index since the dog days of the 2008 financial crisis:
Graph 1
One of the easier trades that can be made in today’s market is one that bets on volatility rising. Even though HCM expects the stock market to rise for the foreseeable future, this is one relatively inexpensive way of hedging that view.
Credit: Another area in which risk is being priced extremely cheaply is corporate bond spreads. Credit default swap spreads on the Markit CDX North America Investment Grade Index, which measures the creditworthiness of 125 investment grade companies in the U.S. and Canada, have tightened inexorably over the course of 2009 and at the end of December stood just above a paltry 80 basis points. This is shown in Graph 2 below.
Graph 2
It is not particularly surprising that these spreads have tightened so dramatically in view of the fact that default risk has receded significantly over the course of the year. The government has made it abundantly clear that it will do everything in its power to reflate the economy, which includes maintaining interest rates at zero and providing liquidity in virtually every form known to man. Moreover, investment grade companies have learned the lessons of the credit crisis and have aggressively moved to extend their debt maturities and improve their balance sheets. Therefore, the default risk on investment grade companies is negligible (barring fraud a la WorldCom or Enron).
The spread on less-than-investment grade bonds rated B is currently about 650 basis points, which is close to its long-term average. See Graph 3 below. In the current environment, which will be characterized by high levels of new bond issuance and low defaults (under 5 percent), spreads could easily tighten another 100 basis points over the next six months and as much as 150 basis points through the course of 2010.
Graph 3
HCM views this spread tightening as a long-term trap. The pattern in credit markets over the past three decades is for spreads to tighten over a period of years until they snap; when they snap, virtually all of the previous gains earned from spread tightening are lost. Accordingly, it is necessary for investors to be extremely nimble in trading and timing the market; buying and holding has served to be a very poor strategy. This boom and bust pattern has been driven by poor monetary and fiscal policy, which is continuing as we speak. While HCM has every expectation that spreads on investment grade and less-than-investment grade debt will continue to tighten for much if not all of 2010, investors should avoid illiquid names (this is primarily an issue in the junk bond market, not in investment grade bonds). Spread tightening in a zero interest rate environment will lead to a situation, particularly in high yield bonds that are quasi-equity securities, where bonds are severely underpriced for the risks that they pose. This is exactly the situation in which markets found themselves in early 2007 before they collapsed in the credit crisis.
Display article as PDF for printing.
Would you like to send this article to a friend?
Remember, if you have a question or comment, send it to .
