“Risk On” and “Risk Off” Are Different Now

Three days ago I put up a post arguing for a “risk off” portfolio positioning.  This extends that thinking.

It used to be simple:  risk off was Treasurys, risk on was stocks and commodities.  Last summer saw mind-numbing volatility in that manner, and a quick drop in the Russell 2000 ETF (IWM) from 85 in July to 61 in early October.  (It has not regained the 85 level.)  IWM is a risk on asset.

Given this New Normal of ultra-low interest rates, what assets are “risky” right now?

Bonds are now riskier than before, including junk bonds, which have gotten marked up in price to provide record low yields.  They lack the guaranteed return of nominal capital of Treasurys, they have no tax advantages as do most munis, they are sensitive to cyclical and company- and industry-specific issues, and they are rate-sensitive.  Plus they have minimal potential for capital gains.  Junk bonds can be thought of as stocks under a different name with high current payout taking the place of retained earnings.

The “stock market” as a whole is a risk on asset.  However, times have changed, and as I have been saying on my trading blog, with the SPY now yielding more than the 10-year T-bond, and with dividend payouts historically low, many individual stocks strike me as less risky than many individual bonds– but more volatile.  I am looking at a Value Line review of an A+ financial strength medical device company.  It pays no dividend but based on its free cash flow, which has grown year after year, could easily yield 4% per year without selling stock or going into debt.  The stock sells at a 40% discount to its theoretical fair value (the so-called “value line”), which given its leadership position in the industry, modest $6 B market cap, debt-free status, etc., means that a stockholder does not have to care too much about slowing growth (which reflects market maturity, cost-containment and expansion issues, but is a “known known” and therefore “priced in”).  Acquisitions of lesser companies in the medical space used to be done at 30X cash flow.  The stock indeed sold for over 30X cash flow only 6 years ago.  The stock price is now lower than it was then but earnings and cash flow per share have more than doubled.  Thus:  the company has several ways to reward shareholders.  The stock price would likely rise if it instituted a large dividend; or, it could be acquired by a GE-type consolidator at what easily could be a 50+% premium to the current stock price.  Could the stock trade lower?  Obviously.  Could the company make a terrible acquisition?  Of course.  But, is a 10-year bond yielding 1.7% risky?  Obviously:  double digit price inflation could appear seemingly out of nowhere, as it has in the past. 

Thus it could be argued that in comparison to a long-term government bond, the stock of the above company (and there are many like it) is less risky than said “high grade” govvie.

So it’s no longer just bonds versus stocks, where only high-yielding stocks of strong stable companies that traded as bond substitutes were safe from a general and sustained stock sell-off such as is typical in recessions.

A high-quality community bank that stayed very profitable through the last few years, has been raising its dividend or at least holding it steady, and is priced close to tangible book value, with a balance sheet that has been “scrubbed” clean by the current stringent level of oversight that bank examiners now provide, strikes me as somewhat of a risk off asset.  Even in today’s market, such a company would likely have a private market (takeover) value well in excess of the current share price, as takeovers of strong banking companies are done well above book value.  In contrast, a TBTF that needed extraordinary help from the central authorities and that maintains a large portfolio of troubled loans is a risk on asset.  The former sailed through the bad times and will likely just see a hiccup in its operating results from a mild recession; the latter requires sustained economic vigor for its bad assets to be made good (and then the stock could soar).  Similarly, a high-quality 5 year tax-exempt bond (yielding next to nothing) is an obvious risk off asset.  A 6-7%-yielding 10-year corporate bond is a risk on asset.

Silver is a risk on asset on a trading basis; opinions differ on physical silver on a long-term basis.  Gold is almost always a risk off asset, as is cash. 

“Growth” stocks are risk on assets.  Utility stocks of ‘A’ or better financial strength are risk off assets (and as income vehicles are so undervalued relative to Treasurys that I think they have high total returns awaiting on a multi-month horizon, though I speculate that Treasury yields are set to rise in the short term). 

Food is a risk off asset.  Even obese people need to eat, LOL.  Thus, companies that occupy leadership positions in feeding the world, given the ecologic stresses, are risk off entities.  If their stocks are already priced to reflect the known cyclicality of the U.S. and global agricultural markets, their stocks may be risk off assets even in a recession.  Everyone is going to choose food over entertainment and even over Internet access.  Thus it was that in the mild recession of 2001 and its aftermath, the stocks of John Deere and AGCO rose despite poor earnings those years.  They traded independently of the market.

In a liquidation effect such as occurred in the late summer and fall of 2008, everything gets sold, but if an asset was underpriced before the liquidation event, and assuming that nothing material happened to it, its price will simply rebound when the liquidation event ends, and likely will move higher over time.

Risk on/off is no longer simply stocks versus bonds.  In 2000, the SPY yielded a little over 1%.  Treasury yields all across the yield spectrum were as high as 6.5%.  The SPY was as high as, perhaps, 30X earnings– and they were near-peak earnings (I think earnings actually peaked around 1998).  That overvaluation of stocks (expensive) vs. bonds (cheap) has now been entirely eliminated due to massive rises in the prices of bonds and price stability for the stock market as a whole despite inflation.  Now both stocks and bonds are expensive on historical grounds.  So in that sense, fundamentally all standard choices are risk on assets; but to say that is to say nothing re asset allocation. 

Smaller and less well-known high quality companies trade more cheaply (i.e. are more attractive) on average than the Dow and large S&P stocks, reflecting lower liquidity.  But I have come to believe that liquidity is a bit of a trap, and now prefer to own whatever asset is relatively underpriced, so long as I obtain current value from owning it and have a foreseeable exit strategy down the road (or, hold forever, as is Warren Buffett’s preference).

It was just a few months ago that I began feeling that the turn would be toward income stocks and away from bonds, which are now in their 32nd year of a secular bull market, when it was reported that the latest surge up in Treasury prices (yields moved down) was being fueled not by the pros but by the general public and, likely, trend-following hedge funds.  Feh!  Even when Japan “went Japanese” financially, 10 year bond yields on their govvies always stayed above current CPI, which was not the case with the 10-year T-bond at 1.5% and below.  Thus it was that I traded out of all my remaining Treasurys at nice profits and began looking harder for stocks that would act as Treasurys have done on trend in 2008 and last year:  rise as the Japanese slow growth, “yotai gap” paradigm continued indefinitely.

Bonds, depending on duration and quality, are moving toward becoming the new risk on assets, with junk bonds probably the worst large asset class I know of from a risk vs. reward basis.

Whatever the asset class, now that almost all asset classes have been pushed to historically high valuations, quality at a reasonable price is the new risk off asset, whether it is called a stock, bond or commodity.   

Unfortunately, investors must accept that nowadays, even risk off is risky. 

The economic data out of Europe and China, the unsettled major nature of the U.S. fiscal cliff issue, and of course the unresolved and historic insolvencies and threatened insolvencies in peacetime of numerous countries in Europe and elsewhere, threaten to shake financial markets up soon.  People who are hiding in certain government bonds and cash because they think they are safe and liquid may be correct on a day-to-day and week-to-week basis but end up finding they do not own what they really want to own. 

Preserving and growing capital continue to require new thinking as prior mispricing of assets is resolved and, as usual, goes too far.

As always, the times are a-changin’.