The Importance of Risk Management in Investing
As a risk manager, my main concern is capital preservation and ensuring that I don’t lose the funds I am responsible for. Whether it’s managing my own investments, allocating funds for individual clients, or working with a trading book on Wall Street, the key constraint is always capital. This is why managing risk is a critical part of the investment process. It is not only a literal aspect of protecting capital, but also a figurative approach rooted in a conservative disposition.
Evaluating the Range of Risks in the Investing Landscape
When assessing the investing landscape, I don’t focus solely on predicting outcomes. Instead, I spend time considering the range of possible scenarios and their corresponding probabilities. While this approach seems rational in theory, the markets often do not reflect it. For example, the current price of oil at $72.60 per barrel does not seem to account for the potential risk of a hot war in the Middle East that could spike prices to $125 per barrel or more.
Balancing Risks: Interest Rates and the Bond Market
The balance of risks in the bond market is towards higher interest rates. Currently, rates stand at 4.11%, down from 5% in October. However, two factors that could lead to lower rates are already priced in: expectations of rate cuts in the short term and inflation expectations of 2.27% over the next five years and 2.30% over the next decade. Additionally, with the trade deficit declining and the budget deficit not following suit, more of the budget deficit will need to be funded from domestic savings. However, the Fed is still shrinking its balance sheet, which pushes in the opposite direction. Thus, the balance of risks in the bond market leans towards higher rates.
Assessing Risks in the Stock Market: P/E Ratios and Profit Margins
The balance of risks in the stock market appears to be lower, especially when considering the “Magnificent 7” hot stocks that have driven market gains. The S&P currently has a price-to-earnings (P/E) ratio of 21.4 and is up 24% since the end of 2022. Excluding the Magnificent 7, the market has a P/E ratio of 18.4 and is up 11%. However, these high P/E ratios are predicated on profit margins that are near multi-decade highs. Thus, the balance of risks for margins is lower, which could lead to lower earnings and higher P/E ratios. It is worth noting that the argument attributing high equity prices to low interest rates seems to have faded.
Considerations for Credit Spreads: Wider Risks and Potential Outcomes
The balance of risks for credit spreads is towards wider spreads, with the 10-year Baa credit spread near historic lows. It begs the question of how low spreads can go. The one-way tails indicate that the risks are skewed in one direction. This suggests that credit spreads may widen, causing additional challenges for the bond market.
Conclusion: Understanding the Balance of Risks in Investing
Understanding and effectively managing risks is critical in investing. While none of the preceding is a forecast, it provides valuable insights into the range of potential risks and outcomes in various areas of the market. Long-only investors may want to consider short positions on the yield curve, focus on credit and inflation-linked investments, and adopt anti-cap-weighting strategies in their stock holdings. Balancing risk across different asset classes and considering a range of outcomes can help investors make more informed decisions and potentially achieve better risk-adjusted returns.
Analyst comment
Negative news. The market is facing risks in various areas such as oil prices, interest rates, stock market margins, and credit spreads. Investors should consider short positions on the yield curve, focus on credit and inflation-linked investments, and adopt anti-cap-weighting strategies in their stock holdings. Balancing risk and considering a range of outcomes is crucial for better risk-adjusted returns.
