By David Schawel, CFA, Economic Musings

It’s only natural that investors begin to pause after such a strong rally in risk assets (in less than 3 months), and reassess whether it makes sense to stay long risk.  No need to rehash why we have rallied as it’s been a confluence of factors worldwide including better than expected US economic data and a easing of stress in the euro zone.  Nonetheless, JP Morgan addressed this very issue this weekend in an excellent “Q&A”.  Here is an excerpt:

1.The fundamentals are no good. The world economy is at 2%, barely growing, with Europe already back in recession, profit margins peaking, and a decade of fiscal austerity holding back the private sector. –– Agreed that the macroeconomic fundamentals are not enticing. But the financial fundamentals of high risk premia versus falling uncertainty are compellingly attractive and truly at the core of what defines asset price value.

 2.The rally is just a house of cards built on easy money. When the liquidity music is over, the asset price bubble will deflate and give it all back. –– High risk premia on equities and credit are indeed due to the near-zero yield on cash and safe government bonds, not because equity and corporate bonds are themselves that attractive. But that is how monetary stimulus works. And central banks will not take back this stimulus until the economies and markets can stand on their own feet, which is several years from now. Remember the old adage of “Don’t fight the Fed”. Surely one should not do so when the Fed works in concord with all other central banks in the world.

• 3. Every one is long now. –– Speculative positions in futures and by macro hedge funds clearly show they are aggressively long risk now. At our Paris Conference last week, 2/3rds of our audience said they were long risky assets. But overall leverage by hedge funds remains subdued, and asset allocators have only shallow longs. Retail investors continue to pour more money into safer bonds funds than equities or high yield. The world as a whole has higher than average cash holdings and some 70% of world holdings offer no positive yield after taxes and inflation.

• What trigger is left to push up risk markets to the next level? –– Accepted there is no obvious trigger as there was before EMU Summits or the Greek restructuring. And our economic growth forecasts are in line with consensus. But within our line of thinking, the true surprise, and thus trigger, is no surprises. High risk premia mean the market is priced for risks and thus negative surprises. If these risks, ill-defined as they may be, do not show up, then that is by itself an event that surprises relative to market pricing.

• There remain tons of risks in front of us. The US and Euro governments have simply kicked the can down the road, China is weakening dramati- cally, and Israel will not wait forever. –– Yes, monetary easing and fiscal stopgaps have simply bought time, but time is what is needed to heal wounds. US fiscal decisions will have to await the elections while Europe has a lot of work to do to put together its fiscal compact. The US Administration will want to exhaust all diplomatic tools before making a military decision on Iran, if it ever will. The markets thus face a lull in event risk over coming months, even as long-term uncertainties remain.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

David Schawel

Economic Musings was founded by David Schawel. David is a husband and father of two living in Raleigh/Durham NC. He currently works as a fixed income portfolio manager. He spent time in NYC in both investment banking and equity research. He is a current CFA charterholder.

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  • Mr. Market

    1. The US has put Iran on the “”regime change”” list in the 4th quarter of 2001. And Iran is still on that list. And Israel is bribing the US to solve the “”Iranian problem””. The US administration supposedly will exhaust every possibility to avoid a war with Iran. But what a lot of folks don’t know is that from day 1 the plan was to “”solve”” the “”Iranian problem”” with military means. All that talk about “”resolving the problem through diplomatic means”” is just “”smoke and mirrors””. Source:
    2. Interest rates are determined by the market (Mr. Market) and NOT by the FED.
    3. Low interest rates indeed encourage speculators to go lever up and go long risk assets.

  • Lance

    It would seem to me that US election risk wasn’t mentioned, but that it might be significant. Should the Republicans win, they may do exactly to the US economy what the Troika is doing to Greece. Needless to say, with Europe bailing water and China in doubt, the stool of world growth certainly wouldn’t have a leg to stand on if that were to come about. In short, saying there are no event risks on the horizon seems myopic to me. None of this means we crash and burn here. But it certainly means anyone buying in here is taking substantial risk, because thing *have* to get better from this point on to drive this market higher, the status quo is pretty well priced in.

  • whatisgoingon

    Cullen been going through your site on older entries and came across an article on excessive risk from April 2011.

    Interesting call on silver and the risk/reward of Europe and Chinese equities. Will you do a 2012 version of excessive risk (perhaps swapping Silver with Apple)?

  • Octavio Richetta

    It is amazing how upbeat people can get after the fact; . i.e., after the huge rally in risk assets.

  • Octavio Richetta

    A rare gift from ECRI. Enjoy!

    The Yo-Yo Years

    ECRI’s Lakshman Achuthan shares his presentation slides and notes from the Bloomberg Sovereign Debt Conference today in Frankfurt, Germany.
    The convergence of two cyclical patterns virtually dictates an era of more frequent recessions in developed economies. As a result, growth in developing economies is going to be jerked around more than people think, making for a good deal of cyclical economic contagion. In other words, we are now in the yo-yo years.
    Click here to download at PDF of the presentation.


  • Octavio Richetta

    Short and sweet. Compare slide 6 to Dalio’s view of the economy as a machine recently posted here.

  • Octavio Richetta

    The ECRI presentation in a much more user friendly format (much easier/pleasurable to read)

  • Andrew P

    The FED does determine interest rates, at least the floor on interest rates. The FED can always peg any interest rate at zero if it so desires. The power of the FED to raise long term interest rates when the market wants them lower is of course rather limited (as Greenspan discovered).

  • Andrew P

    The biggest risk here is of divided government. Historically, a Republican President with a Republican Congress has been fiscally stimulative.

  • VII

    If your going to guarantee a recession and now claim several stop and start recessions…..I would recomened not allowing the one person who can prevent a recession to be your client.
    It borders on absurd. How do you get any recession so long as your allowing the FED to see your research. Not only should you not fight the fed but you should stop scaring BEN that a recession is coming…cause that will guarantee it never comes.
    I’d cancel the Feds subscription and Lakshman may have a chance.
    Further…now your taking your show on the road to Europe? Lakshman has no chance of this being right. Now that he has given every central banker a dose of economic fear… They will go all in.
    I wouldn’t guarantee a victory in a war because the opponent is out of bullets….and allow the guy win charge of all the weapons and limitless bullets to receive your research. It’s just silly. How can he not see the Trojan horse never works when you tell them your inside?

  • Larry

    The Fed is powerful most of the time, but isn’t always. Look at the summer of 2008. The Fed probably had plenty of warning, but were not able to prevent Sept & Oct 2008 crash from taking place.

  • hangemhi

    “historically” they weren’t screaming that the debt had to be brought down, and there was a lot of room to bring tax rates down on businesses and the wealthy, which they did. They also threw tons of money at the military. But now???? For one, they claim to want to lower the debt. Two, there’s not much room to cut taxes for their pets – the wealthy and large corps. And even if they do, they’re sitting on tons of cash so anything extra is likely to just get saved. As for the military, despite Romney’s assertions, there isn’t much room to grow the military from here. Finally, if they get the spending cuts they want – things like entitlements is all money that gets IMMEDIATELY spent into the economy. So I see nothing the GOP has proposed, or is likely to do, that would be stimulative.

  • Octavio Richetta

    This ain’t no war and no one should be either calling or Rooting for a recession. The economy is a complex system. We all have biases. I am just trying to form the most accurate picture I can/minimize uncertainty. I am just going to stick to what LA recommends in his little book. Stay out of stocks during downcycle calls/go long when he reverses the call.. If I had followed this I would not have come out of stocks prematurely in 2009 and would have stayed long until at least through 2010.

  • VII

    Larry- Bens name is on this recovery.
    He’s like a meth addict on a 30 day binge, holed up in a hotel one hand on printing press the other on a button that buys up treasuries.
    Just staring at the crack of the hotel door shadow…so scared the recession will come knocking at his door he just keeps firing the press or hitting the button.
    This isn’t 2008. We compare and refer every thing to two horrible years…1929, 2008. Every positive is cut down by ….yeah but in 2008.
    How do we invest if we fear a recession with every ISM.

    CHINA- they will determine how hard they land. Not a bunch of experts who’ve never been there.
    EUROPE- a couple of months ago EUROSTOX were trading at 1982 valuation levels and everyone balked. That opportunity is gone. It’s no wonder no one buys at the bottom.
    SPX-who knows…Dr. Hussman just came out tonight saying the duration of SPX is 50 years. NO it’s not I hold stocks for 3 months in this environment. And the he says the fed will push everything to zero. Thus….you’d think hed have his aaahaa moment when he realizes that over the next 12 months stocks will go from worse to worst.
    I don’t know of any decline or recession which could start when everyone but Wall st and the media believes its right around the corner.
    The public wrongly thinks its 2008 no matter how many times they write 2012 on there checks.

  • Larry

    @VII, thanks for your comments. I agree with you that we are probably in a 2 to 3 month tradeable rally here (extension of the current 6 month rally from the Oct. 3rd low). I doubt very much if this current rally will go beyond the end of May, but who knows? April is historically a strong month. So I am belatedly and cautiously going long here, but not 60% long as you said you are. Just 20 to 25% long, and keeping my finger close to the sell button if any of the headwind risks we are facing come to the fore. Good luck!

  • Gerald P

    Please explain how Israel “bribes” the US?

  • eric

    those are valid point with just one answer i didn’t agree

    “But that is how monetary stimulus works. And central banks will not take back this stimulus until the economies and markets can stand on their own feet, ”

    whoever said is should look at the oil price now. The more money you put into the system will only increase the commodity price as well. Hello 5 dollar / gallon goodbye obama