Pavlov's Dogs—An Overview of Market Risk

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Risk and Certainty

It is always amazing to observe how people become less risk averse after risk has markedly increased and more risk averse after it has markedly decreased.

The stock market is held to be 'safe' after it has risen for many weeks or months, while it is considered 'risky' after it has declined. The bigger the rally, the safer the waters are deemed to be, and the opposite holds for declines. At the March 2009 low, the daily stock market sentiment index (DSI, a daily sentiment measure of futures traders) had declined to an all time low of 3%. In other words, 97% of traders were bearish at the lowest risk buy point of the past 15 years.

One term that is associated in peoples' minds with rising prices is 'certainty'. For some reason, rising prices are held to indicate a more 'certain' future, which one can look forward to with more 'confidence'. 'Uncertainty' by contrast is associated with downside volatility in stocks. In reality, the future is always uncertain. Most people seem to regard accidental participation in a bull market cycle with as a kind of guarantee of a bright future, when all that really happened is that they got temporarily lucky.

Short sellers are a very small group of market participants. This is not surprising. For one thing, falling stock prices have negative psychological connotations. Most people naturally gravitate to the optimism attending rising prices. For another, the gains a short seller can make are limited, as a stock cannot go below zero. Last but not least, stocks (as measured by stock indexes and averages) actually rise about two thirds of the time. This is mainly due to two reasons: constant monetary inflation and the 'survivor bias' of the indexes.

Short sellers don't have it easy – their research has to be superior to run-of-the-mill research, they are often forced to endure mass outbreaks of irrationality (think internet bubble) and when prices actually fall, they are usually vilified and falsely blamed for 'making' prices decline.

To this day many people are e.g. blaming the failure of Bear Stearns and Lehman to short selling activity in their stocks. In reality, both firms were stuffed to the rafters with worthless mortgage-backed toxic dreck on extreme leverage and were essentially among the 'walking dead' in the weeks preceding their downfall. The short sellers were merely cognizant of this reality.

As noted above, the market rises about two thirds of the time, so it is generally safer to be a bull. For instance, perma-bullish analysts like Laszlo Birinyi or Abby Joseph Cohen can be sure that they will be right 66% of the time by simply staying bullish no matter what happens. This utter disregard of the risk- reward equation can occasionally lead to costly experiences for their followers when the markets decline. For instance, A.J. Cohen's 'must own' basket of technology stocks for 2001 eventually declined by nearly 90%. Laszlo Birinyi fell in love with a subprime lender in early 2007 due to its high yield. To be sure, he didn't recommend to bet the farm on it (quote: “Don't put your retirement funds here or take a large position, but at four times trailing earnings, it's cheap. And there has to be a bottom somewhere.”). There actually was a bottom somewhere: strong technical support was found at zero.

risk appetite index
The 'risk appetite index', an amalgam of the Citigroup Macro Risk Index, Westpac Risk Aversion Index and UBS G10 Carry Risk Index Plus. The herd simply follows prices – click for better resolution.

A Well-Trained Herd

What makes the current juncture especially fascinating is the fact that the Fed has fired its 'QE' bullet at a time when 'risk assets' appeared already fairly overbought and inflation expectations were near the high end of the range of the past five years.

Few people seemed to take this fact into consideration: the herd has been well-trained by Ben Bernanke and reacted according to the experience made during the last two 'QE' iterations. Note however that $40 billion per month in additional Fed balance sheet expansion isn't what it once used to be. It remains to be seen how much of it will 'leak out' into the money supply (this will partly depend on how many securities are bought from non-banks and what the banks decide to do with the additional excess reserves that will be created).

The point is that there is actually no precedent for the current situation. Previously the Fed intervened or announced upcoming interventions at junctures when the markets were in trouble and close to 'oversold' status, with inflation expectations very low. Note in this context that former 'hawk', Minneapolis Fed president Narayana Kocherlakota has joined the dovish camp at this rather unusual point in time. The recent burst of market enthusiasm has meanwhile been accompanied by an inordinate number of technical divergences, including a strong warning sign in the form of a Dow Theory divergence between industrial and transportation stocks. All of these are to be filed under 'they won't matter until they do', but it would be a mistake to simply ignore them.

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