Risk Dynamics
How changes in risk can be more impactful than risk itself
In markets, returns and risk are joined at the hip. If you want higher returns, you’ll likely need to stretch out into more uncertain assets. If an investor wants to beat treasuries they’ll need to move away from the risk-free guarantees that they provide.
But, this coupling of risk and reward are typically associated with long term returns. And, in general, very long term. Meanwhile, investors have witnessed several booms and busts; multiple lost decades in modern markets, both domestically and abroad; and bear markets occurring with regular frequency. In some cases, the equity risk premium may have been negative: 1980’s Japan or the U.S. dotcom bubble come to mind. But most of the time, there has still been an equity risk premium in excess of the risk-free rate.
So why do we see negative returns then? Bear markets can sometimes be caused by shocks to the system. Wars, recessions, pandemics are all things that can cause abrupt changes to future cashflow projections. But often times, bear markets can just be a result of changes in sentiment.
But what does this mean? Changes in sentiment? How is it that the mood of market participants can lead to the rising or falling of the market? Pundits will tell you things like “there’s more sellers than buyers”. And that’s true. But, at it’s core, a sentiment change is market participants saying that they want more return for the risk they’re taking in the market. If investors think the market is riskier this month than it was last month, they’ll want higher forward returns to be compensated for the higher risk. But in doing so the market has to be repriced downwards. And that repricing can often dwarf the returns from the cost of equity, alone.
As an illustration, let’s imagine two investments: one “safe”, the other “risky”. I’ll use two corporate bonds as an example. The first is a 30 year Apple bond; AAA rated. The other is a 30 year AT&T bond; BBB rated (still investment grade, but certainly higher risk). I’ll use the average yields as of this writing: AAA bonds currently yield around 5%, BBB bonds are roughly 7.5%.
Now imagine Apple and AT&T were to switch bodies, Freaky Friday style. AT&T goes to sleep Monday night as a putrid, sad little company, barely covering it’s loan obligations, selling HBO to make ends meet; and then wakes up on Tuesday morning with a pristine balance sheet and tons of cash flow. Apple, the opposite. They wake up and their balance sheet was exported to Quicken, probably a fire in the corner of the office somewhere. Those poor Apple shareholders.
What happens to those bonds? AT&T bonds will rise overnight by almost 40% while Apple’s would fall by 30%. All because the risk level of the businesses has changed. In AT&T’s case, 5 years of returns were pulled forward overnight.
Obviously these things don’t happen overnight, but they can happen over time. If AT&T were to turn things around in 10 years (which isn’t extraordinary by any means) they’d see a tailwind of 2.5% annualized excess returns (above their 7.5% coupon) over that period.
Bringing this back to general markets; this same phenomena happens with regularity.
Take the most recent extreme example: Covid. The economy and markets were humming along heading into 2020, then bam. Future cash flows are in doubt all of a sudden, risk shoots up, and markets crash. The Fed response was to to drop interest rates to zero and the fiscal response was to issue PPP loans and send stimulus checks to households.
When markets look the best, and are priced as such, the only possible upside is capped at the cost of equity for the market. It’s here where markets are susceptible to downside risk, and even black swans.
Conversely, it’s when things look the worst, and the market is priced as such (“blood in the streets”) that re-rating can lead to excess returns above the cost of equity. If the market goes from very risky to less risky (or even “safe”), we’d see an AT&T like return in the example above. And in the case of Covid, vaccines being discovered and the economy restarting improved sentiment and reduced risk, which led to markets being buoyed, resulting in returns well beyond just the cost of equity. The Fed holding interests rates as low as they did even led to valuations “overshooting” a bit - CAPE ratios hit 40 in December of 2021, the highest since the Dotcom bubble. The only difference between Dotcom and Meme Peak was that the risk-free rate was nearly 7% during Dotcom, while it was still under 2% at the Meme Peak making stocks not as objectively overvalued (but that’s a story for another post1).
One of the tell-tale signs to judge how market sentiment is shifting is by looking for PE expansion or contraction. Markets are priced by a combination of forward cash flow expectations, the risk-free rate, and the equity risk premium. Rising multiples can be caused by either increasing cashflow growth expectations or declining cost of equity (led by falling of either the risk-free rate or the equity risk premium).
In the case of the past year or so, we’ve seen U.S. market PE multiples expand at the same time as rising risk-free rates. Following the logic above, that means that expected future cash flows have risen or that investors view the market as being safer than it was in the past (or some combination of the two).
When optimism reaches levels of extreme, the prudent investor should lean towards a more defensive stance.
An exercise investors can do to explore potential opportunities in the market is to look at riskier investments; things that others don’t want to touch. Developed international, emerging markets, china, junk bonds, SPACs are all things that have fallen out of favor in the past couple of years (and in some cases - ehem, international - even longer). Then ask yourself if these investments are as risky as they seem to be priced. In the case of Developed International, PE ratios hover around 13 - almost half of where the U.S. trades. Their black eyes include the near zero growth prospects (both past and future), disorganization (Brexit), geopolitical strains (Ukraine, Middle East, China trade issues). These things may be correctly priced. But it’s also when things look the worst that moving to “less bad” can provide excess returns and moving to “safe” can provide extraordinary returns. If growth expectations pick up (from the currently low bar of near-zero), or geopolitical issues resolve over time, it really wouldn’t be a stretch to see international returns exceed U.S. by 2-4% annually for the next decade.
That’s not to say that anything is a guarantee. Things can always get worse (in the case of international) or they can always get better (in the case of U.S.). But if you want exposure to excess returns, this is the way to think about the world.
For relative valuation studies, see my previous posts: Bonds Away and To Bond or Not To Bond.