Why I Reduced Investment Risk Last Week



  • I reduced the risk of my investments last week because I believe investors are now inadequately compensated for assuming risk. My action was primarily based on risk premiums most easily observed in the High Yield and Emerging Market bond markets.
  • I was also influenced by expectations that the Federal Reserve will continue to tighten monetary conditions. While initial Federal Reserve rate increases are often associated with strong stock market returns, historically tightening has eventually resulted in stock market losses.
  • While this essay explains my action, it also explores a number of good reasons to believe my decision is inappropriate for other investors, incorrect, and/or too early.

Risk Premiums

Figure 1 shows three “risk premiums”: 1) the yield spread of high yield bonds over Treasuries, 2) the yield spread of Emerging Market bonds over Treasuries, and 3) the implied volatility of S&P 500 options. The red dashed lines show the 10th and 90th percentile levels, while the blue dashed line is the median value. All three measures indicate investors see very little risk currently.

Figure 1: High Yield, Emerging Market and S&P 500 Risk Premiums

All three measures also indicate how skewed risk and reward is currently. If high yield spreads decreased tomorrow from their current value of 3.7% over Treasuries to their 10th percentile value of 3.04%, investors would earn 2.6% in market value appreciation (assuming a duration of 4 years). If, however, high yield bond spreads increased to their 90th percentile value of 8.4%, investors would lose about 19%. That is not a very favorable risk/reward ratio.

Figure 2 illustrates the fact that high yield bond, emerging market bond and stock market returns have been highly correlated in the past. This leads to the general observation that it is unlikely that one of the three asset classes will do well if the other two perform poorly.

Figure 2: Trailing 12 Month High Yield, Emerging Market Bond and S&P 500 Returns

Risky Asset Returns And The Federal Reserve

Historically, risky assets have continued to perform well through the first part of a Federal Reserve tightening cycle. In a sense the first few rate increases by the Federal Reserve validate investors’ perception that the economy and earnings growth are strong. It is not uncommon, however, for investors to begin to worry after additional rate increases. Some investors begin to fear that the Fed will go too far and cause a recession. Higher short term Treasury yields also begin to seem like an attractive alternative to remaining invested in assets which could lose money.

This interplay is shown in Figure 3: higher short term rates influenced by the Federal Reserve and falling long-term Treasury rates due to growing concern about slowing economic growth cause the 10 year - 1 year Treasury yield spread to approach 0. Poor stock market returns often occur subsequent to that yield curve spread decrease (leading to the old market maxim “don’t fight the Fed”).

Figure 3: Trailing 12 Month S&P 500 Returns vs. 10 yr - 1 yr Treasury Spread

Figure 3 shows that the 10 year/1 year Treasury spread is not yet at zero. So one can certainly argue it is too early to reduce portfolio risk. That may indeed be the case, but Figure 1 also shows you are not being paid very much to guess correctly exactly when a market sell off might occur.

Worry When Insurance Becomes “Cheap”

Another indicator that has changed behavior recently is the increasing potential payoff of a long term S&P 500 put option (e.g., LEAPs). Figure 4 shows the percent payoff to a 10% out of the money LEAP if the S&P 500 were to fall 40%. This recent increase in potential payoff reflects the fact that LEAP options are cheap because implied volatility is so low. An increased potential payoff also occurred (well before) the significant market sell offs following the bubbles of 1999 and 2007. Again Figure 4 (which is really just a restatement of low VIX levels) suggests it may be too early to reduce risk, but I sense increased wariness is warranted.

Figure 4: Payoff to 10% Out Of The Money LEAP to 40% S&P 500 Sell Off

Why A Sell-Off Of Risky Assets Could Be A Year Or More In The Future

I’ve already mentioned several reasons reducing risk in your portfolio may be premature: spreads have been slightly narrower in the past, the 10 year/1 year Treasury spread is not yet at 0, and potential LEAP payouts have been even higher than they are now.

Figure 5 also shows that a reasonably reliable (but not infallible) predictor of recession -- the Duncan Indicator (based on the cyclical components of GDP) -- is not yet signalling an imminent recession.

Figure 5: Duncan Indicator As Predictor Of Recessions

Finally, another scenario that could prove me wrong is if corporate earnings growth meets strong expectations. Ultimately the S&P 500 closely follows corporate earnings. Currently, bottom up equity analysts expect S&P 500 annualized earnings growth of about 16% through 12/31/2018. That’s about 80 to 90% higher than historical median annual earnings growth since 1988. But if it happens, the stock market should rise commensurately. S&P earnings growth does historically exceed US GDP growth.[1] But with expected long-term nominal GDP growth of around 3.3% (based on productivity growth of about 0.7%, population growth about 0.6% and inflation around 2%), those expectations seem high to me.[2]

More Reasons To Ignore What I’m Doing

Market timing is notoriously difficult, and most people advise against it. Certainly for the young with nearly all of their asset accumulation ahead of them, reducing risk makes very little sense. For the young, the best strategy is steady saving and investing in broadly diversified global funds with low fees.

However, for those who are not likely to accumulate substantial additional assets (retirees and pre-retirees), the cost of a false positive (i.e., acting on an incorrect signal to reduce risk) is much lower relative to the potential benefit of escaping a significant market sell off. Accepting modestly lower returns in the near term -- perhaps a year or so -- may well be a good strategy.

For me the compelling reason to reduce risk is illustrated in Figure 1: I believe you simply aren't getting paid enough now to be heavily exposed to risky assets.

[1] The S&P 500 exhibits “survival bias” because Standard & Poor’s continuously adds faster growing companies and drops slower growing companies from their index.
[2] See “Secular Trends” tab of http://rpubs.com/whelanh/MarketAnalysis

Transparent and reproducible: Figures can be generated by using the free, publicly-available R program and the R code (with free data links) available in “reduceEquityRisk.r" on github.



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