It’s interesting how risk appetite’s have changed so dramatically in the last two years. Why is this interesting? Because, when you look under the hood at the Global economy you’ll notice that the problems that caused the car to veer off the road are all still in place. Nothing has really changed. We still have the same global imbalances that caused the crisis. The Chinese are still causing imbalances within their economy via a flawed currency peg. The single currency system with the Euro is still causing imbalances throughout much of Europe. And the financialization of the US economy is continuing along its merry way.
But, from an investor’s perspective there has been a distinct “risk on” trade in place. This is not surprising because asset prices are rising and the economy really is improving, however, you probably would have felt the same exact way in 2006 or in 1998 when everything appeared just fine. The truth was, risk management was probably more important at these two points in history than ever. John Hussman elaborated on this in his most recent letter:
“I recognize that investors are eager to move on to the thesis of sustained economic recovery, with no need for any risk management at all. However, it appears unwise for investors to rest their financial security on faith in a recovery that relies on the government running a deficit of 8.5% of GDP, simply to keep the existing 6.3% gap between actual and potential GDP from widening further. It appears equally unwise to rely on Fed purchases of Treasury bonds to sustain ever greater exposure of investors to risk, when the creation of financial bubbles does nothing to increase the underlying cash flows deliverable by the securities that are increasing in price.”
This sort of herd mentality might make the entire herd feel a bit more safe. The only problem is, the issues that caused this crisis to begin with are still stalking the herd. They’ll catch up with it sooner or later. It might happen in the next few weeks, months, years or even decade. No one can be sure exactly when, but they will catch up with it. And when they do the herd will disperse in panic and once again investors will have wished they’d been more aware of the potential risks at hand. Although fear and greed will continue to alternate dramatically during the investment pendulum swing, risk management is never going out of style.