Monday, June 25, 2007


I went over to Wikipedia and found this engineering definition of risk:

Risk=(Probability of an Accident) X (Losses per Accident)

I like this definition because it's quite easy for everyone to understand. It's the reason you buy insurance for your car or your house. Doing so is a form of risk management that we all practice. Now, there are many that simply don't understand the concept of risk when it comes to investing. Maybe that is because if you did, you might pull your money out of mutual funds, hedge funds, private equity or other investments, thereby interrupting a very handsome fee structure for those in the investment community who are typically paid on how much money is under management instead of returns. In other words, as Paul Farrell has often said, (I'm paraphrasing) Wall Street wants to keep investors in the dark. Well, as I've said before, in almost every regard investments are at a much more heightened period of risk than in 2000. How are global investments protected in such a period of significant risk? What risk management practices are employed?

As we've all heard by now, Bear Stearns, a Wall Street icon, is bailing out one of its hedge funds to the tune of nearly $4 billion. If people actually believe Wall Street is managing risk properly, I've got some news for them. How about 1929, 1987, 1937, 1921, 1998, 2000, 1977, 1970, 1990, 2007 etc, etc, etc. As I've written before, Wall Street is always wrong eventually. They are very wrong this cycle. Much of what I model involves esoteric risk factors. In April, I witnessed a five standard deviation event in a long term and relatively normal distribution series. That data series measures risk appetite. What does that mean in English? That means we're basically experiencing a once in a life time event where risk appetite is incredibly strong. Yet, risk appetite should actually be very muted were companies practicing strong risk management. So, while I have written about a very significant top being put in this cycle, the measurable data points are unfolding which support such a position.

Is it really an epiphany that a financial institution revered for its risk management practices hasn't managed risk properly? The surprise is that people seem surprised. Last week I wrote that interest rates were likely rising because of risk and not because of inflation or growth. What does this mean for equities? Let's look at the flip side of something else I wrote last week. That growth companies are less prone to exogenous financial shocks and typically have less debt and therefore are less affected by interest rate changes. This cycle has been led by deep cyclical company out performance. As the markets start to price in risk, what will happen to companies that actually have increased their debt load this cycle or have substantial debt loads as deep cyclicals typically do? In other words, companies that may have not managed their risk properly. The corporate bond market has been extremely kind with very low credit spreads. That has contributed to artificially inflated earnings. What happens to earnings when risk starts to be priced into the corporate debt markets? Especially if earnings concomitantly peak? Even if rates don't go up? Indeed. If credit ratings are changed, the effect is the same; higher debt costs. In other words, we don't need to see a large rise in market rates just a rise in risk.

Risk=(Probability of an Accident) X (Losses per Accident)
posted by TimingLogic at 10:17 AM

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