Markets No Longer Know How to Define ‘Safe’

The prevailing feature of the recent turbulence is that nothing has really worked as it was supposed to work.  

Markets No Longer Know How to Define ‘Safe’
A trader works on the floor of the NYSE in New York, on March 12, 2020. (Photographer: Michael Nagle/Bloomberg)

(Bloomberg Opinion) -- If the recent selloff in markets proves anything, it’s that for too many years too many people were focused solely on returns with zero consideration for risk or safety. The last time anyone really thought about safety in markets was during the financial crisis more than a decade ago, when investors couldn’t get enough government bonds or cash.

But as the economy recovered, so did investors’ appetite for risk. A sort of cult of equity developed, with the unshakable belief that stocks would keep going up, and if they ever went down – which they did fairly sharply in the second half of 2015 and the end of 2018 - they would always come back – which they always did. “Buy the dip” became an actual strategy. The American Association of Individual Investors found that its members had an almost 66% allocation to stocks in December, up from 41% at the bottom of the financial crisis.

More importantly, the definition of safe morphed as stocks soared to new heights. If you went to your financial advisor and told him or her that your risk tolerance was low, he or she probably would have put your money in a portfolio of stocks that had a history of rising, not because they had any defensive qualities. But as we have seen this month, all stocks can go down with equal ferocity. That cult of equity has been shattered – perhaps permanently.

The prevailing feature of this bear market is that nothing has really been safe. If you had any exposure to bonds, it was probably in the form of investment grade or high-yield, high-risk debt, which were down almost as much as stocks until the stimulus packages from the government and Federal Reserve. And nobody contemplated a scenario where municipal bonds would not be safe. General obligation munis are backed by the unlimited taxing power of municipalities, but yet they were not spared, and that market ceased functioning.

U.S. Treasury notes and bonds did provide some diversification benefits, but only to a point. After yields bottomed a couple of weeks ago, a massive unwinding of certain trades and the promise of massive government borrowing to fund the fiscal rescue plan drove yields higher. For decades, bonds mixed with stocks was good enough to achieve diversification, but will probably be less useful going forward.

Gold has been a bit of a disappointment. The whole reason people buy it is for situations like this, and it hasn’t worked, initially taking a big dive from about $1,680 an ounce to $1,471 in a matter of weeks. Although something similar happened in the last crisis, with gold peaking early at $1,000 as Bear Stearns collapsed, and then proceed to go down as the financial system unraveled, before finally turning and surging to $1,900. Although gold has rebounded somewhat, those expecting gold to go up when stocks went down were let down. Similarly, Bitcoin has also been less than underwhelming. The digital currency, which sometimes trades like a haven asset, has mostly traded as a risk asset instead, though it has also recovered somewhat just like with gold.

Money market funds are struggling to avoid a situation like what happened in 2008, when the Lehman Brothers bankruptcy caused the Reserve Primary fund to “break the buck,” which led to a run on money market funds. The commercial paper market is smaller than it used to be, but money market and ultrashort duration bond funds don’t strike me as very safe here without help from the Fed.

Only Treasury bills or cash would have provided you with the safety you desired. But cash has its own set of issues and concerns. If you have more than $250,000 in one bank, there is a chance that it’s not entirely safe, either, which people were forced to think about in 2008.  Also, it looks like the government and the Fed will be dropping money out of helicopters, and people are - perhaps prematurely - starting to talk about inflation again. So on a long-term basis, cash makes less sense.

As for as the safety of different investment vehicles, exchange-traded funds that own bonds are again taking heat for trading at a significant discount to their underlying assets  (though I wrote about this a few years ago, and it is a feature, not a bug, of ETFs). And we are again looking at a situation where there is a possibility that open-end mutual funds might gate redemptions for liquidity reasons. 

All of this forces an investor to ask themselves what is safe? Is anything really safe? The days of dollar-cost-averaging a standard portfolio where 80% is invested in stocks and 20% is invested in bonds and watching your money grow at 10% a year and end up with a few million dollars at retirement are likely over. Returns will undoubtedly be lower, forcing people to save more and consume less—which is not what is needed for an economic recovery.

My beliefs about risk were shaped years ago reading books such as “The Black Swan” and “The (Mis)behavior of Markets,” which focused on ideas like how financial markets follow a power-law distribution, and not a normal distribution, and that markets are vulnerable to large, unforeseen events. Knowing this, you try to build a portfolio that gives you a modicum of exposure to the upside, but truncates your exposure to the downside.

The bears and the financial doomsday preppers were widely ridiculed during the bull market.  I won’t say they have been vindicated, but people’s perception of risk has been forever altered.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of "Street Freak" and "All the Evil of This World." He may have a stake in the areas he writes about.

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