Appetite for danger wanes
Risk has been like chocolate or champagne in financial markets for the last few years: The more of it investors had, the more they wanted.
Last week, some of those same investors came to acknowledge that bingeing on anything really can hurt you, or even kill you.
The global plunge in stocks and other high-risk assets may have had several causes, but at its heart the sell-off was a retreat from risk-taking.
The critical question now: Is this retreat a short-lived phenomenon or will it be long-lasting?
That’s a more important question for the economy than simply whether stocks are in a short-term pullback or beginning a new bear market.
A prolonged turn away from risk taking, for example, could close off a hefty chunk of the U.S. population from the easy credit they’ve had access to in recent years -- particularly via so-called sub-prime mortgages.
Turn off that money spigot and consumer spending could take a substantial hit, which in turn could have dismal implications for economic growth.
The specter of a credit crunch was one of the fears that moved to the front of investors’ collective psyche last week.
Yet like other worries that periodically boil over in markets, it’s far from certain that anyone will even remember the latest batch a year from now.
Stocks also plummeted in May and June on concerns about the economy’s health. It was a false alarm, and by August share prices were climbing again. As the old Wall Street saying goes, the stock market has predicted 30 of the last five recessions.
Market volatility feels so scary in large part because investors have experienced so little of it in recent memory. Since 2003, the global economy has been booming and stock prices have been in a powerful uptrend, with few interruptions.
Until Tuesday, the blue-chip Standard & Poor’s 500 stock index had gone 949 trading days without a 2% or greater decline in a trading session, according to S&P; strategist Sam Stovall in New York.
That was the longest such streak since 1950.
A related bit of perspective: It’s normal within a bull market for the S&P; 500 index to periodically experience pullbacks of 10% to 15% before resuming its advance. Yet there hasn’t been a 10% decline in the index since the first quarter of 2003.
This environment has been wonderful for investors, but it also has encouraged some of them to take risks that would fail the prudent-man rule.
“It was a market where you could just grab handfuls of stocks, and the riskier the better,” says Jack Ablin, chief investment officer at Harris Private Bank in Chicago.
That fueled the “carry trade.” For years hedge funds and other speculators have been borrowing money in Japan at rock-bottom interest rates and using the loan proceeds to invest in high-risk assets around the world -- emerging-market stocks, for example, and U.S. high-yield “junk” bonds.
Everyone knew that at some point interest rates in Japan would start to rise, cutting into the profitability of the carry trade. And if the yen strengthened at the same time, the speculators would face a double whammy: higher credit costs and the rising burden of paying back yen loans with a weaker currency, such as the dollar.
When the Bank of Japan raised its benchmark short-term interest rate from 0.25% to 0.50% on Feb. 21, the carry traders suffered a blow.
It got worse for them last week, when the dollar plunged from 121.08 yen to 116.75.
Investors’ focus early in the week was the dive in the Chinese stock market, which was one of the triggers for Tuesday’s global market slump, which saw the Dow Jones industrial average lose 416 points.
But the trend of the yen may soon trump anxiety about China.
As with the dot-com mania of the late 1990s, the risks inherent in the carry trade and other speculative strategies haven’t been hidden. But it was easy for the players to figure, “I’ll just get out before the inevitable bust.”
Sort of like, “I’ll stop drinking before it becomes a problem.”
How much unwinding of carry trades and other leverage-based techniques is yet to come? That’s one of the market’s most troubling unknowns.
“We have no idea how big the carry trade is,” says Marshall Front, a veteran money manager and chairman of Front Barnett Associates in Chicago.
“What did they buy? How much leverage was used?”
One type of leverage can be measured. Margin debt -- the sum investors have borrowed against their accounts at New York Stock Exchange-member brokerages -- reached a record $285 billion in January. That raised some red flags because the previous peak was $278 billion set in March 2000, at the zenith of that era’s bull market.
The unwinding of high-risk bets is part of the natural ebb and flow of markets, of course. The danger in the near term is that it may cause a chain reaction of retrenchment trades that drive the market lower, in turn causing other investors to pull back as well out of fear.
Retrenchment already is well along in one sector: sub-prime mortgages, which are loans to people with bad credit histories or no credit histories at all.
That business has been imploding as many of the biggest lenders sink under the weight of rising loan defaults.
Many analysts -- and some Federal Reserve board members -- continue to assert that the problems in the sub-prime business won’t lead to broader credit problems in the economy. They may be right.
Nonetheless, the sub-prime sector’s collapse obviously is a problem for people who had counted on that credit either to fund a new home purchase or to extract equity from the home they’re in.
“By any other name, you’d call it a credit crunch,” says Kevin Caron, investment strategist at brokerage Ryan, Beck & Co. in Florham Park, N.J.
“The real economy doesn’t have access to the same sources of capital it clearly had a year ago.”
That’s also a problem for the stock market, Caron says, because it raises the risk that the U.S. economy could tilt into recession rather than enjoy the “soft landing” that had been the overwhelming market assumption just a week ago.
Caron believes there’s a 1-in-3 chance of a recession beginning late this year. That’s enough of a possibility, he says, to make him want to reduce the risk in his portfolio.
That means staying away from emerging-market stocks and real estate investment trusts, sectors that have led the bull market since 2003, Caron says.
He may be too cautious. Fear was rampant last spring, as well. Investors would have fared better if they’d been in the market at the time, picking up beaten-down stocks.
Still, this is a good moment for investors to decide just how much pain they can take. Most major world stock markets are down 5% to 10% from their recent highs. So long-term investors haven’t lost much. There’s time to decide whether you need to act.
And for those who have been waiting to buy, the markets’ tumult could present a great opportunity.
Times like this force people to reevaluate what risk means to them. That’s healthy, even if it’s no one’s idea of fun.
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This pullback and the last one
Despite the severity of last week’s sell-off in stocks, major market indexes worldwide have fallen only modestly compared with the hits they suffered in the spring and summer of last year.
*--* Mid-2006 decline Latest decline Russia/RTS -30.0% -8.9% India/Sensex -29.2 -12.1 Mexico/IPC -23.7 -8.3 Japan/Nikkei -19.0 -5.5 U.S./Russell 2,000 -14.1 -6.5 Germany/DAX -13.8 -6.0 U.S./S&P; 500 -7.7 -5.0
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Source: Bloomberg News
