Market Musings Blog

Risk is slippery, risk is nuanced. Most folks forget the negative side of risk, instead remembering the old saw, ‘the more risk you take, the more return you earn’. Here are some situations that can fool the mind:

• You buy a start up biotechnology company with no earnings and as yet, no product. It goes up 100% in a year. Is this risky? Yes. In this case, the risk paid off in the short term, but you could just have easily lost all your money.
• You buy an early stage technology company with some earnings and two products. It sinks 90% in a year and then goes out of business. Is this risky? Yes. In this case, you took risk, and the portion of the adage above that is never quoted – ‘over time’ – raised its ugly head. You need several risky transactions in a diverse portfolio and a lot of time for that adage to work out. Between first investment and realizing a high return, you will put up with a lot of volatility and some disasters.
• You go in with your brother to build two spec homes in Boulder, CO. It is 2007 and homes in Boulder have gone up a lot in price. Is this risky? Yes, and you are about to lose a lot of money. You will have to wait until at least 2015 to regain most of your investment. If you have to sell before then, you lose money.
• You are one year from retirement and you have 90% of your funds in stocks. You need to live off your portfolio when you retire. None of your stocks pay dividends, but you do have 10% of your assets in bonds. Is this risky? It depends. If you have enough money and can adjust your budget to big market downdrafts, it is not as risky as if you need a fully reliable draw that is on the high side relative to your portfolio size. It IS risky, because you are betting on an unreliable phenomenon – appreciation – to pay your way. But how risky it is, is situational.
• Oil prices are down 66%. Exxon is trading 30% below its 52 week high, at its low for the year. You decide to buy Exxon stock. Is this risky?

The answer to the last scenario is where nuance arises. Exxon didn’t look risky when oil was at $110 a barrel and the stock was at $100 a share. Now, with oil at $37 a barrel and the stock at a 52-week low, it looks risky.  But: is it? Stay tuned for Part III.

The Third Avenue Focused Credit Fund, aka a junk bond mutual fund, moved swiftly to prevent redemptions by transferring the fund’s assets into a liquidating trust today. With the assets locked up, and no cash flows in or out unless at the behest of the fund manager, the manager hopes the underlying junk bonds can be sold in a rational way, rather than at fire sale prices forced by shareholders wanting their money. The fund owns some of the shakier issues available in the market, on the theory that many of these could heal themselves and prove to be more valuable later.

But the market has moved against the fund as the situation in the oil patch begins to spread beyond energy alone.

Unfortunately, the formation of the liquidating trust means shareholders can’t get their money until Third Avenue decides to make sales. So this is what can happen to a mutual fund in a distressed situation. In an extreme situation, if an investor’s whole portfolio was invested in, say, three funds that behaved this way, his money turns out to be locked up.

We are not fans of mutual funds, and this situation just provides more ammunition against these overblown products.

Aside from recognizing this event as an investment risk, it shows how fragile some areas of the economy are. Liquidity has dried up in some assets. Who needs the Fed when you have the markets to make interest rates for shaky credits leap well into double digits? And now, with the Fed actually on the brink of a rate hike, we’ll see who else is naked as the tide goes out.

The Fed’s zero interest rate policy, aka ‘ZIRP’, was devised to turn the 2008/09 downturn from a potential depression into merely the Great Recession, and as far as anyone can tell, it worked. However, ZIRP has continued far longer than anyone thought likely.

A change from ZIRP does not necessarily mean increasing rates across the board. It will mean short rates will rise, when and if the Fed finally acts. We call that ‘normalization’ these days, since zero as a rate is abnormal. The question is when is the Fed going to act. The past couple of years have offered many opportunities but none has been quite good enough, apparently.

This last time around, the Fed held up because the global economy looks as though it is weakening. Worse yet, third quarter earnings reports look paltry, and layoff announcements are increasing in the US. This could amount to a mere slowdown or it could mean a shallow recession. If enough such signs proliferate, we expect ZIRP to persist into 2016. It’s not that 25 basis points makes that much difference. It’s that once the Fed hikes, the next topic of speculation will be when will it happen again – another element of uncertainty. The mere fact that investors are so focused on ‘will they, won’t they’ tells us that there isn’t enough else that is good about the economy.

What if ZIRP itself is causing the slowdown at this point? ZIRP has led to overcapacity in many industries, and now it is braking the process of correcting those bubbles, which is deflating many commodity prices. And low interest rates have not helped much to reduce household or other indebtedness in the US; in fact, ZIRP is akin to solving a borrowing crisis by spurring more borrowing. Student loan debt, subprime auto loans, energy company debt – there’s a lot of it. Economies expand when borrowing starts from a low base, but we are already at a very high base. There aren’t many people left who need to, want to, or even can borrow.

So while ZIRP has undesirable elements, we may be stuck with it for a while, because the cost of a hike is growing by the day.