Prior to the onset of the financial crisis in 2008 there was a generalised belief that ‘risk’ could be managed, typically via the use of an expensive piece of software that produced a lot of Greek sounding statistics and plenty of pretty charts.
The advent of systemic risk in 2008 showed that many of these processes for managing risk were really measuring risk, with an assumption that the future could be inferred from using the past as an example. Backward-looking statistics rarely suffice at times of crisis and 2008 was a spectacular example of this. Quantitative appraisals of risk need to be used alongside fundamental appraisals of risk, so with that in mind, what should common sense be telling us today?
Unlike 2008 and 2011, there is now an acute awareness of the risks surrounding markets, be it the fiscal cliff, the European economy, the Chinese slowdown or Japan’s attempts to weaken its currency. Against this backdrop though, markets are noticeably higher than 12 months ago and behaving in a rather bullish manner, with the recent superstar asset, government bonds, starting to deliver negative returns.
This does sound somewhat paradoxical: investors remaining very concerned yet markets rising. There is a well-known investment maxim about bull markets climbing a wall of worry, but our analysis of investor positioning is that though they are sounding worried, they are fully invested. Equally interesting is that while the genuine bulls are calling for a significant turn in the US economy, the most popular holdings with investors tend not to be equities that would benefit from this trend, but rather those equities that are viewed as ‘safe’.
Safety appears to be the most comfortable way to invest. For instance, well-financed companies with global brands and solid profitability are now generally trading at premiums to the market, whereas the direct beneficiaries of an economic renaissance – house builders and retailers for example – are largely being shunned. Many investors have chosen ‘safe’ business models even though the relative valuation of these shares means, perhaps, they have never been more unsafe.
Valuation is one of those common sense risk measurements that investors need to keep in the forefront of their minds. We all strive to identify that undiscovered investment opportunity in the belief that when others identify, they will bid the price up to a level where there is no longer any value left and move on to the next opportunity. We were attracted to safe business models when they were good value, but today they represent a risk to investors’ future returns as any change in the need for safety could see these investments decline rapidly.
Another factor to consider is that when investors decide that they want the safety of cash, the only assets that may be realised are those that are owned, so it is likely that the most over-owned expensive assets would be sold to fund panic moves to cash. We suspect that these assets may prove to be disappointing, failing to capture an economic upswing but also failing to defend in the annual panic that seems to occur in the second or third quarter.
It will be very interesting to see which assets do well in this phase, particularly if ‘safety’ underperforms.
Marcus Brookes is head of multi-manager at Cazenove Capital Management
