Rethinking risk

JP Morgan’s $3 billion losses stemming from its risk management operations reminds us that balancing risk with reward requires constant vigilance. After all, JP Morgan, like fallen angel Goldman Sachs, were purported to have come through the 2008 global crisis in admirable form, even as many of their peers teetered on insolvency.  

Whenever past trends are taken for granted, the markets turn what then becomes conventional wisdom on its head. After supporting its currency for years, Russia’s unexpected devaluation of the ruble in 1998 led to Long Term Capital Management insolvency. Similarly, it was not long after average US home prices began to fall for the first time in history that global equity markets lost more than half their value.  

Below I discuss a couple investment ideas that deserve further investigation.  

 

“Invest in necessities” 

Investing in basic necessities (ie, food, shelter and clothing) is an axiom that in the past has sheltered investors through difficult times. What could be more basic than putting food on one’s table? Yet investing in grocery store stocks over the past decade have been anything but defensive.  

Recall in late 2010 that A&P, once the world’s largest retailer, filed for bankruptcy in late 2010. Ruthlessly competitive and beset by minuscule profit margins, traditional grocery stores are losing out to Wal-Mart, organic grocers (eg, Whole Foods) and even quick-casual restaurants. Today, the three largest grocery stores in the US have a combined market capitalization that’s about one-tenth of Coca Cola’s, maker of soda pop. 

Rather than investing in food stocks one might do better owning tobacco stocks – hardly a necessity. Former food and tobacco conglomerate Altria separated its tobacco businesses from Kraft Foods in 2007 and 2008. Since the spin-off, Philip Morris International, the overseas arm of the tobacco maker, stock price has climbed some 70 per cent, over which time Kraft, the world’s No. 2 food-maker (after Nestle) stock has risen less than 20 per cent. Today, Philip Morris international is more than twice the market capitalisation and earns more than double the profit of Kraft, even though sales, excise and income taxes add up to about 90 cents of every dollar paid for a pack of smokes. 

Housing has sheltered investors from risk no better than food. In fact, if you had sold your home in 2006, at the market’s peak, and sold short Pulte, not only would you have avoided an average loss of 35 per cent on your residence’s value, but you would have benefited from a 75 per cent depreciation in the stock of the country’s largest builder. 

 

The “risk free” rate 

Investment professionals frequently refer to the risk-free rate, as measured by the 10-year US Treasury bond, as the standard by which other forms of risk are commonly measured against. Because these obligations are backed by the full faith and credit of the US government, these bonds are considered risk-free.  

Although the US government has never defaulted on its debt, the likelihood that this enviable record will be sustained was first put into doubt last summer, when Standard & Poor’s cut the government’s debt rating to AA+ from AAA. Debt was put into technical default later in 2011, when Congress delayed increasing the federal debt ceiling. 

Not only is the risk free rate free from default risk but, recently at an all-time low of 1.7 per cent, the 10 year’s yield is highly exposed to other types of risk. An immediate risk for long-dated Treasury investors is interest rate risk – the possibility of future increases in interest rates that would push bond values down.  

Yet the good news is that interest rate risk can be avoided by holding the bond to maturity. Investors unable or unwilling to hold a bond for 10 years, face the possibility that price increases (ie inflation) will outstrip interest rates, leading to a real loss in purchasing power, or negative real returns. 

Investors must ask themselves if government bond yields below 2 per cent are the next bubble, set to burst over the coming years. Consider past bubbles in stocks and housing:  

 

In March 2000 per share corporate earnings yields (1 divided by the S&P 500’s P/E of 33.8 times) bottomed at 3.0 per cent. Over the next two- and a half years stocks fell a full 50 per cent.  

In mid-2006, when US home prices peaked, median rental income yields (gross annual rent divided by comparable home sales price) bottomed at 2.5 per cent. Six years later, existing home sales prices have fallen some 35 per cent, based on Case-Shiller.  

These failures are reminders that placing too much reliance on past trends can lead to costly investment mistakes. Investors should always question the conventional wisdom, especially when investing in the trends they reflect. 

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information. 

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