WHERE IS THE EXCESSIVE RISK RIGHT NOW?

My mother tells me I predicted the housing bust.  My father tells me I predicted the market crash in 2008.  Readers believe I predicted the flash crash last year.  None of this is true.  I don’t predict anything.  I can’t predict anything.  No one can.  But that doesn’t mean you can’t take highly calculated risks. The intelligent investor does not need to be able to predict the future.  He/she merely needs to know when to fold ‘em and know when to hold ‘em.  In the investment world, nothing is more important than knowing when to fold ‘em.

When I review the housing bubble I was far from predicting what ensued.  I didn’t ever imagine the crisis that would unfold.  All I knew was that there was a trend in US housing prices that was unprecedented, inconsistent with underlying fundamentals and unsustainable.   I recognized a disequilibrium in the market.  But my conclusion was not of the magnitude of “genius” like John Paulson, Kyle Bass or Michael Burry.  No, my conclusion was far simpler.  I just stayed away.

You see, playing with bubbles is a dangerous game.  The difference between being John Paulson (who shorted sub-prime) and Julian Robertson (who shorted the Nasdaq bubble too soon) is a matter of months in the life of a bubble.  Without a doubt both men are market geniuses.  The difference, however, is that one had lucky timing and the other didn’t.  I would argue that the truly intelligent investor simply pulls his chips back and steps away from the table for awhile in the midst of such irrationality.  Warren Buffett is probably the best case of “don’t mess with what you don’t understand”.  And in the case of bubbles, I would argue that no one understands the market’s behavior.

As I have previously discussed, market bubbles are the most severe cases of disequilibrium.  It is the point in the market cycle where the system becomes highly unstable to the point of losing all linearity and entering an entirely chaotic orbit.  This makes for a market environment that can be highly rewarding, but astronomically risky.   But market don’t have to be in bubbles to be extraordinarily risky.  What appears like a perfectly stable system can very quickly devolve into a nightmare.

With that said, are there examples of this in today’s markets?  Are there markets that warrant a “do not enter” sign?  I believe so.  And if I were an investor in the following markets I would merely pull my chips off the table, take a long deep breath and walk away from the table.

1)  China

China remains one of the great “if it’s too good to be true it probably is”.  This economy is growing at a rate that is incomprehensible to most westerners.  But the cracks have started to show in the facade.  Between their reverse mergers, supposed GDP fraud, accounting scandals, highly flawed monetary policy and insanely inflationary fiscal policy (where they just build empty cities in the middle of nowhere) I have to wonder what breaks the back of this economy at some point?  My guess is that inflation will rage in China to the point of public discontent and ultimately harsh economic repercussions.  The bottom line: the risks of investing in China are enormous.  For the majority of us, it’s simply not worth taking the risk. 

2)  Municipal bonds.

I don’t think there’s a major municipal bond crisis on the horizon.  I’ve been fairly vocal about that.  On the other hand, I have to accept the reality that the risk of a funding crisis is very real.  This would most likely arise in the form of austerity due to politics, but the odds are that it could happen.  With so many other options in the bond world one has to ask him/herself why they would bother taking the risk of buying municipal bonds?  The mere potential for collapse in what is supposed to be a fairly low risk asset class is too much for me to bear. 

3)  Silver

This is not a popular call, but investing isn’t a popularity contest.  The bottom line is that silver prices are on an unsustainable course.  If I had to pick one bubble in the world today it would be the silver market.  As is always the case, the fundamentals are always superb in a bubble, however, the market action never quite correlates appropriately.  As I’ve said before, silver prices could double from here.  On the other hand, they could also crater.  If I am going to invest in precious metals there are lower risk ways to obtain exposure.    

4)  European equities (particularly periphery nations)

Few things are more confusing in the world of macroeconomics today than the crisis in Europe.  There is simply no telling if the region will collapse or unite.  And while I think we are likely moving closer to some form of unity I have to also acknowledge that collapse is a very real potential.  In the broad world of equities there is simply no reason to bother investing in European equities.  This is particularly true for the periphery nations which are now serving as high beta form of their core brethren. 

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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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