Thoughts While Taking Up Carpets: Risk and Reward Misaligned
I’ve spent the last few days taking up carpets, removing curtains, and packing up boxes, which doesn’t allow much time for writing. However, it leaves plenty of time for thinking. As I pulled up tacks, I marveled at the normalcy that has returned to the financial markets. After the Great Depression, it took more than a generation to cast off the lessons of stock speculation and excess credit. We’ve managed to forget those lessons in less than six years. While current conditions don’t begin to resemble the full-blown mania of the credit bubble, we’re committing all the same sins on a smaller scale.
Perhaps the most unsettling development is the complacency that envelops the financial markets. Last night I had a look at the VIX, which is a measure of anticipated volatility. In other words, traders buy and sell the VIX as a bet on whether the S&P is going to be more serene or choppier in the future. At the moment the VIX is at 11.9%, which is about as low as it’s been in 20 years. A level of about 18% to 20% would be normal, and readings of 40%, 50%, or more signify frighteningly volatile markets. This morning I discovered that the Federal Reserve has been looking at the same data.
Low expectations for volatility would be okay if investors weren’t also taking on more and more risk. In other words real risk is rising, and yet investors are shrugging it off. For example, junk bond issuance is rising back to pre-credit crisis levels. In particular, the issuance of payment-in-kind (PIK) bonds are risking rapidly. Rather than paying cash interest, a PIK bond pay interest in the form of more debt. Leverage ratios for corporate buyouts are expanding, and covenants (investor protections) are waning. Meanwhile, the boom in tech and biotech stocks has faltered, and many secondary stock offerings are seriously under water. Still, investors seem quite sanguine about stock market risk. Once again, investors think they have the market figured, which is usually when things go wrong.
Why have we returned so quickly to a complacent investment environment? I’m guessing that we have a massive agency problem. The professionals piling into risky assets aren’t doing it with their own money. Instead, folks like you and me are putting money into mutual funds and hedge funds with the expectation that professional money managers will find us higher yields in a low interest environment. Pensions and endowments are hiring all sorts of private equity, real estate, and credit managers to search for riskier opportunities. Money managers are happy to oblige.
I don’t know how long this period of complacency will last. Eventually some shock will jolt investors, and the VIX will soar. You and I will wake up to the fact that we were taking too much risk and begin to redeem our mutual fund and hedge fund shares. Ironically, the pain caused by roiling markets will be a healthy sign because risk and return will once again be aligned.