May 2012 Ushers In “Risk Off”

Since the financial crisis of 2008, some new financial terminology has evolved to describe market timing trading activity by large institutional investors like hedge funds.  This trading has contributed to increased correlations among traditional equity asset classes and is an annoyance to long term investors.

The trading is usually triggered by systemic events or news and is termed “Risk On” and “Risk Off.”  Risk Off means global macro traders sell and even short sell riskier assets like equities and commodities and buy U.S. Treasury bonds and safe-haven currencies like the U.S. dollar.  When these traders go Risk On they do the opposite, buying equities, certain commodities, and currencies and short sell Treasuries and other currencies.  Since the beginning of May we have witnessed another period of Risk Off, triggered, once again, by news out of the Eurozone. 

A few weeks ago, France and Greece voted Socialists into power, calling into question the bailout austerity agreements in place for Greece.  (These austerity agreements, incidentally, had caused the Risk On bull market condition starting in October 2011 through March of 2012.)  The elections of socialists increased the risk that Greece will fall out of the European Union, the ramifications of which are highly uncertain and possibly chaotic.  Markets hate uncertainty, and the uncertainty with our own budget deficit, debt, JP Morgan proprietary trading losses, and Presidential election cycle don’t help, nor does the much-anticipated Facebook IPO falling flat on its face.

The 10-year Treasury bond yield has fallen to as low as 1.7% during the latest Risk Off period, and the energy sector has gotten hammered right after expectations of a heavy summer driving season drove gas prices up. 

Our strategy

Obviously, Risk On and Risk Off traders have had an impact on volatility in global capital markets.  The one saving grace for us is that options premiums have increased.  We have been able to buy back many of our June options positions profitably and have been able to “re-write” some June options at lower strike prices.  Otherwise, since nearly all of our May options positions expired out-of-the-money, we would like to see a bounce in the markets before establishing the rest of June and July options positions.

We have international equity exposure through ADRs and broad-based asset class ETFs that mimic the MSCI EFAE (EFA) and MSCI EAFE Value indexes.  EFA has nearly 1,000 companies whose largest holding is Nestle SA which has a PE ratio of 5 according to Morningstar.  BP PLC also has a PE ratio of 5.  The majority of the country exposure is Great Britain, Japan, and Australasia.  It does have some bank exposure, but we believe most of the bad news is already priced in to the international banking sector.  We think panic selling an entire asset class when valuations are this compelling is a mistake, particularly when we can generate 1.2-2% in call option premium on June expirations.

One day, we believe this crisis will be history, but no one knows when that will be.  We are watching the situation in Europe closely.   Greece and France are attempting to form coalition governments in June, and euro-zone officials are contingency planning for Greece falling out of the Euro.  We believe every effort will be made to prevent that from happening but have read some reports that that would not necessarily be a bad thing either.  We think at some point there is a likelihood our global-macro traders will be Risk On.

We will keep you informed, and, as always, don’t hesitate to call.