Wax On, Wax Off

When anyone refers to the daily price action in financial markets as “risk on,” it makes me lose my freaking mind! It’s like being forced to watch the NBA Finals games from the ‘80s when the Lakers lost to the Celtics, while simultaneously listening to the Beaches soundtrack on repeat. It drives me crazy! That’s because there is no such thing as financial market risk being “on” and “off.” This isn’t the Karate Kid, you aren’t Ralph Macchio, and I’m sure as heck not Mr. Miyagi. There is no risk on, risk off, Daniel-son.

Risk is always on, my friends. The problem is that most investors have no idea what the word “risk” really means. I’m going to do my best to awaken the risk manager that lies dormant inside you. But be forewarned: once awakened, you won’t like what you see in financial markets at the moment.

 

S.A.T. Words

Raise your hand if you’ve ever been put to sleep by your finance adviser spewing terms like beta, standard deviation, kurtosis and skewness. I feel your pain.

A lot of the confusion comes from the fact that the words “risk” and “volatility” are used interchangeably. Let me be clear, risk is not volatility; they are two different beasts.

Standard deviation and other measures of volatility are not measures of risk. These calculations may make you feel warm and cozy, but they can’t help you understand risk, because risk is not a number.

So, what exactly is risk? 

Risk is uncertainty about the likelihood of a permanent loss of capital if an unfavorable event occurs.

I’ve left you wanting, haven’t I? You wanted me to tell you the index, calculation or statistical measure that would help you discern just how much risk exists in the world, and more importantly, in your portfolio. I’m sorry, but I can’t. We can’t boil risk down to a number, but we can assess the probabilities of various outcomes and then position our portfolios in a way that tilts the scales in our favor.

If you are using volatility measures to determine how much risk is in markets, or your portfolio, then you are being taught karate at the Cobra Kai dojo. You might kick butt and take names for a while, but we all know what happens in the Championship Bout. You get your butt handed to you by a 135-pound kid who normally gets sand kicked in his face.

To give you a better sense of what risk looks like in the real world, outside of the Excel spreadsheet, here are some risks that I’m seeing right now.

 

Contradiction Risk

I’m not sure if there has ever been a time when central bank policy risk was more elevated that it is today. Take last week’s ECB meeting; the whole world was waiting with bated breath to see if Draghi would announce a taper.

Well, he didn’t, but he did talk about the euro’s strength, calling it a “source of uncertainty which requires monitoring …” He went on to say that the ECB’s discussion of revisions to their quantitative easing strategy was “very preliminary.”

The contradiction risk is that the market believes the ECB is going to taper while the economic data suggests they should continue along their path of easing.

The ECB has a desired rate of inflation, which is 2% annually. The problem is that eurozone inflation has spent a total of only five months out of the last four years above even just a 1% annual pace.

In fact, the rate of inflation has hit 2% for just one month since 2013. That was back in February, and it’s been declining ever since.

Maybe the ECB is willing to overlook the lack of inflation in order to taper. But are they willing to overlook a lack of inflation plus a slowing of growth?

Eurozone growth is starting to follow inflation’s lead lower. Few people are talking about it, but Germany has been slowing for four months now. The trend is downward, and I expect to see growth in other eurozone countries following suit.

The only reason the ECB would take its foot off the easing pedal when both growth and inflation are slowing is if they wanted to cause a recession.

You can’t put a number on this contradiction risk — where the market believes one thing but the data suggest a different path — but it brings a great deal of uncertainty, particularly about the future direction of the euro, and the risk is real.

 

Relationship Status Risk

I’m not talking about the kind of relationship risk that occurs when you decide to be honest how those jeans make her look fat or his bald spot isn’t so subtle. I’m talking about the relationships between and across markets. Bill Nye the Science Guy would call this “correlation.”

Right now, just about every major market on Earth has a negative relationship to the U.S. dollar and U.S. yields. As I pointed out last week, the weak dollar has been the catalyst for a number of popular and very crowded trades this year.

These relationships bear monitoring because if the dollar and U.S. yields begin to rise in concert, perhaps because the euro weakens, the time it would take for those overly popular trades to unwind could be measured with an egg timer.

Markets don’t go straight up or straight down. At some point, the dollar and yields will find their footing. Even if these markets only muster a six to eight week countertrend rally, a lot of this year’s profits could quickly evaporate.

Keep in mind that the status of relationships between and across markets is constantly changing. Awareness of these shifts can provide you with valuable insight into risks and opportunities that most investors miss.

You can’t quantify “relationship status” risk and the accompanying uncertainty, but the risk is real.

 

The Bottom Line

Human beings are hardwired to hate uncertainty. But if you think about it, there is no great reward if you don’t embrace uncertainty. The first time you asked your significant other out on a date, were you certain he or she would say yes? Of course not. There was uncertainty and a possible loss of ego if an unfavorable event occurred and they said “no.”

If you’re thinking of leaving a 20-year steady, paying gig to join a start-up because you want to control your own destiny and earn “buy-your-own-island” money, is there certainty? Nope. My friends, all of life’s greatest rewards live in the land of uncertainty, and successful investing is no different.

To earn great, risk-adjusted returns, you must embrace uncertainty and have a process for understanding the ever-changing and unintended sources of risk that lurk in financial markets.