Listening to a major financial radio broadcast this morning while putting the finishing touches on this issue, I heard some of my favorite themes discussed. One, by a former colleague, was the prevalence of benchmarks as a possible explanation for the S&P 500’s resilience, however narrowly based, this year. As long as the world focuses on benchmarks, managers hoping to stay employed have little choice but to go along. It’s the stuff of my first book, The Undoing of Cowardice, in which I argued that the financial crisis happened not because of too much risk in the system (well, perhaps that was there too) but because of the risks were too similar in too many portfolios. What may be perfectly sensible for any given manager wanting to preserve his or her job is potentially catastrophic for the overall market. I continue to believe sensible policy needs to take this more into account.
Another theme of note: investors taking more risk in reaching for yield. One of the broadcasters quite sensibly discussed how investors are likely to find new ways to sell volatility to extract a bit more income, and how this could backfire in a rather huge way. No doubt. But it’s important to remember that virtually all fixedincome strategies involve selling volatility, whether explicitly or not. Whenever I lecture on campus, I try to ask students whether buying non-convertible bonds involves buying or selling volatility. I think students answer correctly about half the time. I do this to motivate the collapsing part of the convertible graph on the far left, when stock prices approach zero. Investors would do well to be far more mindful of this. Buying weak-ish credits for mid-single-digit yields is nothing if not selling volatility at dangerously low levels.
With this in mind, I was concerned to read that Treasury issuance will be shrinking. This not only augurs badly for future convertible issuance—at least on the premise that we need higher rates for more paper—but also reminds us that we are passing up a generational opportunity to rebuild our nation’s embarrassing infrastructure with cheap money the world wants to lend us. It’s sad to watch an opportunity of this magnitude get wasted.
How about those Warriors?
(This is the cover letter for the subscription-based weekly Hillside's Hybrid Vigor newsletter. For a complete copy, please contact John Anderson at + 1 (646) 712-9289 x 107).