FYI | Jun 22 2006
By Greg Peel
Risk measurements are many and varied. Some economists measure "risk appetite", some "risk aversion", some "investor confidence" and others whatever they will. FN Arena has been following the path of risk measures all this year, and suffice to say there is contradiction amongst them.
Assessing risk appetite in debt instruments is easy. Debt trades at a price which reflects a yield required by the buyer (lender). Subtract the "risk free rate" (usually the cash rate) from the yield and you have the "risk premium". If premiums rise on average, investors are risk averse. If they fall, investors are happier with risk.
Unfortunately, it doesn’t work that mathematically for non-debt instruments. There is no obvious risk premium built into equities, as a premium to valuation can result from a number of factors. Commodities are hard to "value", so there’s no help there.
Economists thus use all sorts of means to "measure" risk appetite across the spectrum of asset classes and arrive at some risk index. Most involve complex econometrics. If you’re into that, you have my sympathy, but I’m not going to attempt to outline any methodologies here, beyond the simple.
In May, Credit Suisse, Merrill Lynch and Morgan Stanley all announced serious collapses in their various risk indices. In other words, where investors had previously had an attitude of "bring it on", reflected, for example, in a raging copper market, they suddenly ran and cowered in the corner as soon as things turned nasty.
Credit Suisse has again reported on the state of its risk appetite measure. It has fallen like a stone since April to be possibly consolidating around zero, which presumably means investor indifference. While the fall on the graph is spectacular, the index had peaked at what CS describes as a "euphoria" level that had never been seen since the measurement began in 1987. That was when commodities were going to the moon.
The driving force behind such euphoria was excess liquidity – the "awash with cash" notion. As global interest rates rise, the cash tap is being turned off. This means less high return opportunities, more risk, and less risk appetite.
However, while the tap might be turning clockwise, no one’s exactly slammed off the spigot. Many analysts suggest that while liquidity has become tighter, it is still easy in relative terms. Thus while there may be a correction, it won’t turn into a raging bear market. CS economists got so sick of hearing this story they decided to check out some measures for themselves.
And like all good economists, they came up with conflicting results. In one measure, centred around global wealth, things look grim. The last time this measure peaked as it did before May this year was before 1987 and 2000. That’s ugly.
In another measure, also using global wealth but then applying all sorts of bells and whistles, things aren’t quite so bad. The measure is only slightly above the trend line from 1985. "This interpretation accords a bit better with the other measures, suggesting there is plenty of value left in both developed and emerging equities", says CS. It’s all a bit Humphrey Appleby, but we prefer this result as well (funnily enough).
CS then argues that one measure is about "change" and the other is about "level" and that probably the truth lies in between. The conclusion is thus: more pain to come but shortly opportunities will again arise to buy risky assets. Which is pretty much the same conclusion as everyone else, except maybe Stephen (Call Me Grizzly) Roach of Morgan Stanley.
Merrill Lynch has certainly arrived at that conclusion.
Merrills’ portfolio strategists note developed equity valuations are touching 30 to 80 year support. And this is "despite risk appetite soaring". What? Soaring? I thought it was collapsing. But there you have it – another measure, another result.
"The key issue for investors is whether markets are trading cheap [sic] due to cyclical factors related to the risk of higher rates and trend reversion in earnings, or whether we have entered a period of structural PE de-rating".
Earlier in the month Merrill’s strategists moved to a "tactical neutral" on risky assets and favoured long duration growth assets. However, they advise their clients who may be underweight risk to start thinking about getting back in to "riskier quality assets". When the Fed’s finished tightening the S&P500 will look attractive, says Merrills, as will Japan.
Overall, Merrills is comfortable with developed equity valuations but warns that earnings are easing. Again, this is a popular view – a bull trend but not quite as euphoric as it was. (Merrills’ resources analysts put forward exactly the same view yesterday).
UBS has also arrived at the conclusion.
It is not a bear market, says UBS. Sell-offs of 10% or so are common, and this is just another one. There’s always a correction following a Fed tightening phase, and 25 years of history suggests buying into corrections is nearly always profitable. On the assumption the world is in for a soft economic landing, this should be another opportunity. There are good medium term buying opportunities right now, says UBS (referring to Australia in particular).
Of course, as a stockbroker, it is never in your interest to call the market down.
Coming back to risk measures, State Street’s investor confidence measure started falling around last November, bounced hard in February, and has been rising ever since. Strange days indeed.
State Street’s measure was developed along with Boston neighbour Harvard U, and works on a quantitative basis by "analysing actual buying and selling patterns of institutional investors". It all has to do with figuring out whether the institutions are holding more or less equities in their portfolios. If they’re holding more, that’s risk hungry. Less means risk averse.
Clearly, the instos have been buying, which State Street puts down to a combination of equity markets having fallen, and that the instos "do not fully share the rising concerns surrounding tighter central bank liquidity reflected by the market as a whole".
US institutions are nothing short of massive, so if they’re buying it can only be a good sign.