Risk: is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss. The notion implies that a choice having an influence on the outcome exists.
When investing, risk is always involved. There is risk of loss of principal if an investment goes down in value. There is risk that an income stream from an investment goes down – a dividend cut for example. A risk exists if you are not invested and the markets rise. There is risk that inflation will eat away at your principal value. In today’s market, it is important to balance these risks. Outlined below are the risks as we see them in the equity market, in the fixed income market and in cash.
Macroeconomic risks (Very High): We believe the macroeconomic risks to the market are high at this time. There are several reasons for this: the ongoing European crisis, China’s financial system experiencing a shock (a great book on this is “Red Capitalism – The Fragile Financial Foundation of China’s Extraordinary Rise”) and the unrest in the Middle East – especially between Iran and Israel. Any one of these events could cause a spark that brings equity prices down around the world.
Corporate earnings risk (High): Corporate earnings have rebounded nicely since 2008. A big part of this rise is because labor output rose – see point A in the charts below. This rise was created when companies laid off workers causing output per worker to rise and in turn causing earnings to rise. This rise in earnings is usually temporary because workers get burned out after 18 months or so causing productivity to drop. What concerns us most is that corporate earnings as a percent of GDP have never been this high in the last 50 years. Every time this indicator has risen 8% or more, the stock market fell the following year. We have seen a drop in productivity over the last few quarters while earnings continue to rise (point B). We believe there will be continued pressure on earnings in the months ahead. If there is, this pressure may cause a reduction in equity prices.
Drop in dividend payout risk (very low): We do not see a significant risk of companies cutting dividend payments. Most companies have excess cash on hand and can withstand a financial shock.
Equity Conclusion: We believe that the macroeconomic risks and the risks to corporate earnings pose a significant risk to equity prices. For these reasons, we continue to believe that a lower exposure to the stock market is warranted at this time. We believe also that the greatest risk lies outside the US and in the Eurozone. That is why we continue to maintain the lowest exposure THOR has ever had in international equity markets.
Interest rate risk (very high): Fixed income (“bonds”) price movements are inversely related to interest rates. In other words, if interest rates fall, bond prices rise. If interest rates rise, bond prices fall. Furthermore, the longer the time to maturity for a bond, the greater the risk of price fluctuation for that bond. With interest rates at historical lows, we think there is a significant risk that interest rates will rise over the next 1-3 years. As such, we want to buy bonds with shorter maturity dates rather than longer maturity dates – i.e., you would not want to buy 30-year Treasuries in this environment.
Credit Risk (moderate): Credit risk is the risk that the company or institution issuing the bonds defaults on the bonds. There is real risk in the municipal bond market – especially in California and Illinois – and in European bond markets. Most American-based companies are doing fine as we have seen corporate default rates drop significantly in the past couple of years.
Fixed Income Conclusion: As we believe the risk of interest rates rising is high and credit risk is moderate, we have balanced our fixed income portfolio between shorter-term bonds and high yield bonds. We do not own any international bond funds at this time.
Inflation risk (moderate): There are two competing sides of the inflation debate: 1) the Federal Reserve printing more money; and 2) credit bubbles (like the 1930s) are extremely deflationary. These competing interests are causing a massive tug-of-war at this time, but we believe the deflationary side is winning. If the Euro does collapse, the dollar will rise and commodities will fall as they have been over the past few months.
Opportunity Risk (low): This is the risk of “missing out” on a major bull run in either stocks or bonds. We don’t believe the most recent run in the market is sustainable because of the macroeconomic risks and the pressure on corporate earnings.
Cash Conclusion: We continue to hold cash because the risks in both the bond market and the stock market are high. When that risk dissipates, we will redeploy that cash into higher returning investments.