A simple concept has been taken to an absurd extreme: Avoiding the safe low-yielding investment and embracing the risky investment that promises the biggest upside potential. Investors seem to have forgotten the definition of risk: '`The possibility of suffering harm or loss" American Heritage Dictionary. Higher investor risk exposure is evident in two areas: 1 ) so-called carry trades in which leveraged players borrow in a low-yielding market and invest in a high yielding one and 2) the flood of money into low-rated credits and equities. These investment flows have warped most global financial markets as investors have elatedly moved way out on the risk (possibility of suffering harm or loss) spectrum.

Let's consider a few examples. The first and most obvious is the infamous yen carry trade-which involved borrowing in yen at around 1/% and investing in U.S. Treasury notes at around 6% A nice juicy yield spread that leverage amplified. It worked for awhile, but the recent collapse in the dollar/yen spread (by 10% in a month) erased many months of gains from the interest rate differential. It has also left slow-moving, late-to-the-party Japanese investors holding the bag on losses from long dollar/U.S. bond positions that have turned into the latest headache for the crippled Japanese banking system. Those losses are likely to increase as the dollar/yen weakens further.

I've previously mentioned the gold carry trade, in which commercial banks and hedge funds borrow at the LOW gold interest rate and invest in higher-yielding Treasury notes, either outright (by borrowing the gold from central banks, selling it forward and using the proceeds to invest in Treasuries), or synthetically through futures, forwards and other derivatives. Another example of borrowing low and investing high (and assuming unseen risk).

Central bank gold leasing is a great example of heightened risk exposure. Most modern central bankers see little value in holding gold as a reserve. Since gold reserves earn no interest, traders are eager to lease it out. The concept of stable reserves for a currency has been replaced by a hedge-fund mentality, in which central banks are eager to become a profit center for parent governments with stubborn fiscal deficits. Central banks would rather own Treasuries and earn 6%, than earn nothing holding gold. Implicit in that appetite for dollars is a higher assumption of risk — their leased-out gold might vanish in a financial crisis ( as it did for Portugal when Drexel went bankrupt), or the value of the dollar might plummet versus their currency. (Japan just suffered approximately a $22 billion loss in the value of its foreign exchange reserves since April 30th, when the dollar peaked).

A fourth example of heightened risk tolerance is evident in the peripheral European bond markets (like Italy and Spain). Bond investors have poured money into those markets on the assumption that the EMU will make an Italian or Spanish bond in lira or pesetas as valuable as a Bund in DM (all in Euros, eventually). French yields have actually traded through (below) those of German Bunds. Are Italy, Spain and France better (or equivalent) credit risks than Germany? Many investors seem to have made that risky bet.

A fifth example is junk bonds. Wall Street has repackaged low-rated credits into collateralized bond obligations (CBO's) and sold them to yield-hungry investors. CBO's are set up as trusts that issue lower/ yielding investment grade debt and equity and invest the proceeds in higher-yielding junk bonds. These securities are way out on the risk spectrum. Wall Street has equitized junk bonds. Hooray for overspeculation. Bond dealer friends inform me that junk is the least liquid market going-dealer bids come with a snicker (try and sell more than a token amount at that price). It's a sector with no exit door.

A sixth example is emerging market debt— spreads have tightened considerably as investors have flocked into high-yielding Latin American and Eastern European paper. Issuers like Brazil and Mexico have found an almost insatiable appetite among foreign investors for uncollaterialized 30 year bonds. The memory of Latin America's recurrent defaults has been supplanted by investor's greed for a hundred extra basis points. These are all examples of markets that have bee inflated by great expectations. Fear is nonexistent. It is almost the exact opposite of Templeton's buy signal (the point of maximum pessimism). Most global markets are now at the point of maximum optimism. By most valuation and momentum measures, we are now way beyond the extremes of late 1993 - early 1994 that directly preceded the collapse in bonds and emerging markets, which caused so much pain to hedge funds and dealers (that memory seems to have been lost through selective amnesia). Naturally, equities are way beyond bonds on the risk spectrum-and most global equity markets are correspondingly more over inflated by irrational exuberance than any bond market. Beneath this backdrop of financial market ecstasy, some global economies show symptoms of stress. The most obvious fractures are in Asian banks. Japanese financial institutions lurch from crisis to crisis (look for losses on their dollar bonds to soon compound those problems). Thailand is trapped in a classic financial meltdown-half-built skyscrapers and construction projects are causing a banking crisis as property value plummet, loan collateral withers and payment defaults multiply. Korea, Malaysia, Indonesia, the Philippines, Taiwan and India have early symptoms of that same financial disease. Most of those equity markets are down significantly from their highs. In continental Europe, unemployment is the highest since the 1930's depression, while socialist governments think the answer is to reduce the work week (for the same pay), prevent companies from closing inefficient factories and create more government jobs. A wonderful recipe for further stagnation. All this alongside unbridled financial asset speculation and zooming stock markets. This is really one for the record books. Desperate central bank money-pumping in Japan, the U.S. and continental Europe has unleashed unrestrained financial asset inflation, while global economies mostly languish. The next financial market downturn from this point of maximum optimism will fall on global economies that are already slowing, stagnant, or where investors and financial institutions are exposed to bloated speculative bubbles in real estate and equities.

U.S. stock market investors seem determined to squeeze the last drop out of the rinds of this speculative bubble. Against the backdrop of historic overvaluation, irrational exuberance, expanded risk exposure and technical hyper-overextension, just what is the upside for U.S. equities?

Who wants to be the last one to buy the market at its absolute high (or even two months before)? The drop after the high tends to lose about 3 times as much (from the original purchase price) as the rally added at the absolute high.

Courtesy of Strategic Investment
http://www.strategicinvestment.com/about.htm

Back to Editorials

           Copyright  © 1997  vronsky  and  westerman