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Markets: Is it Getting Riskier?
New York: October 31, 2005
By John R. Stephenson

As investors we've had it pretty good. Interest rates are low and the stock market has being chugging along for a while with steady and predictable performance. We've had a couple of years without a major corporate hick-up and our monetary policy has been slow and steady, even predictable. All of this has made it easy to plan but hard to outperform the broader stock market. It has also been great for our real estate investments with more than seventy percent of Americans now homeowners. But, lately, things seem to be a little less certain. Consumer confidence is waning. The political landscape seems to be shifting right in front of us. Inflation is back on the march. And some commodity-oriented stock markets such as the Toronto Stock Exchange have witnessed a steep sell-off of energy and commodity oriented stocks. While it may just be the October effect, you have to wonder if things are getting riskier?

It appears so. In investing, risk and return go hand in hand. But most of us think only in terms of the potential returns (profits) that we might be able to make and conveniently forget about the risks that we may be taking. When risks are high the variance of our returns is large. Or, in other words, we can make a lot and we can loose a lot - depending on luck and skill. When markets are less risky, we can make less but we also risk less. In times when risks are high, then stock markets offer more potential profits but also more potential downside. While risk (or uncertainty) has remained muted for some time, things appear ripe for a change.

Perhaps it's the never-ending stream of natural disasters ripping through the gulf coast region. Or maybe it's the announcement of a new chairman for our central bank (Federal Reserve). Or maybe it's the whipsawing we are witnessing in the global energy markets, but regardless of the cause, uncertainty is on the rise and we can measure it.

But it hasn't always been this way. In fact, over the last few years the stock market (at least from a risk perspective) has been positively benign. That was then, this is now. Today, risk is on the rise. This can be measured in several ways. One is through the VIX index, which is a measure of market volatility (risk). Another more simplistic method of measuring market risk is by measuring the percentage of trading days that the S&P 500 has made a greater-than-2% intraday move. By both these measures, risk is on the rise and investors had better get used to greater swings in the value of their portfolios. Not only that, but also, this increase in risk has come after a period of relative calm in the markets. And while it may not be the calm before the storm, you have to wonder if this prelude is going to catch many of us asleep at the switch.

Figure 1: S&P 500: Percentage of Days with an Intraday Move Greater than 2%

Source: FactSet Research Systems and Bear, Stearns & Co. Inc.

The complacency that we have seen in the market isn't just limited to stocks. This complacency has pervaded every market including real estate, bonds and emerging markets as well as the stock market. The upshot of all this complacency? We are much more vulnerable to surprises or changes in the marketplace than if we had been living through riskier times. This fact has not escaped Central bankers such as our own Alan Greenspan who commented that market participants have become too sanguine about risks, and thus vulnerable when a big shock hits.

While certain market participants, namely hedge funds, are cheering the return of higher risk (volatility) they are in the minority. Hedge funds like increased risk because for them it spells opportunity. They think that their active management style and liberal use of leverage (borrowed money) will help them to magnify the profit making opportunities that they identify. Most of us aren't using increased volatility to generate outsized trading profits, we are buy and hold investors for whom increasing risk (volatility) means that the downside in our portfolios is starting to loom large. Not only that, but research has shown that while risk or volatility, as it is referred to in the industry, can take stocks up (positive variance) can also take stocks down a whole lot faster (negative variance). In other words, when risk in the market increases, investors have to be more cautious about extreme movements to the downside, rather than extreme moves to the upside.

But what could cause market uncertainty to increase? Many things. While some seventy percent of S&P 500 companies have reported earnings with most (67 percent) managing to beat consensus expectations for earnings, this positive momentum in corporate earnings could start to slow. If corporations start to announce poor earnings or at least miss the expectations baked into the forecasts of Wall Street analysts, this could lead to a rise in stock market volatility (risk). Companies with greater leverage (debt on their balance sheets) are most at risk to see their prices tumble when investors en masse decide to send share prices down. High oil prices could supply a necessary shock through a slowing of the global economy which could serve to increase the risk to investors. Other things that could upset the apple cart include: inflation, surging U.S. government and personal debt levels as well as a change in the currency policies of Asian countries.

Who is to say what will tip the balance? But there is little doubt that something will. Investors who are worried about rising volatility (risk) in their portfolios should diversify their portfolios - the only free lunch that there is in investing. One way to diversify amongst different sectors at extremely low cost is to consider buying exchange traded funds ("ETFs") which offer diversification for a fraction of what it costs to be in a managed fund. Other strategies? Investors should consider lightening the load on the financial service sector which typically benefits from falling interest rates rather than rising interest rates. Energy, which appears to be in a secular bull market, is another sector of the market that is likely to offer investors outperformance.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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