Risk On: Was 2008 Just a Bad Dream?by
The ghosts of 2008 linger. They haunt an economy that’s slowly and unevenly recovering from its worst shock since the heyday of bread lines and Hoovervilles. The financial crisis taught us that long-held assumptions and complacencies can and will fall apart in a subprime minute. Markets tanked. Credit dried up and marginally financed companies went under. Banks failed. Even today, whole subdivisions of newish homes remain abandoned, their copper pipes ripped out and their pools sporting a phosphorescent, almost otherworldly, shade of green.
Point is, the concept of risk is not to be underestimated. In mere months, American household wealth took a brutal, $14 trillion hit. That’s more than $120,000 per household. And lest you thought a snapback in 2009 and 2010 made things perfect once again, Europe’s fiddling last year while Rome (and Athens and Lisbon) burned sent volatility soaring and markets tanking all over again. Some economists swear we are only in the middle innings of a potentially decade-long financial crisis.
So how is it that risk concerns suddenly feel so fuddy-duddy? Small- and medium-capitalization stocks are up about 12 percent so far this year, as measured by the S&P 1000 index, and are about to cross an all-time high. Junk bonds are all the rage. These are issued by companies that have far less financial self-determination than such blue-chip, dividend-paying stalwarts as Johnson & Johnson and Intel. The giants’ universe, the mega-cap S&P 100, is up only 8 percent year-to-date. The tech-laden Nasdaq composite, meanwhile, is up 14 percent.
In trader parlance, the mass flocking to lower-quality assets is called “risk-on,” perhaps as homage to revered sensei/mentor Mr. Miyagi from The Karate Kid. Consider that large companies are trading at a 21 percent discount to small-capitalization companies, according to the Leuthold Group. Mega-caps are even cheaper, changing hands for less than 11 times estimated 2012 earnings, compared with a multiple of 16 for the small fries. Big, stable and cash-rich gets you so little respect these days. Even with bonds and certificates of deposits yielding next to bupkis, you can hardly give away a safe and chunky dividend.
Investors have been lulled by a drop in volatility, which, as measured by the VIX index (chart above), has plummeted 65 percent from its highs in August. Then, fear and loathing about a European contagion was in full bloom. Today, the VIX is back at levels it enjoyed in the last complacent months of mid-2007. You know, back when buyout firms believed they could take a three-legged ox private—and at a multiple of eight times cash flow.
Maybe, just maybe, we’re completely out of the woods and 2008 will turn out to have been one brutal aberration. Homes could fill up. Banks could lend with abandon, as the Dow zooms up to 20,000 and unemployment falls back under 6 percent. “Now we’re getting a resumption of the economic growth that seemed to have faded in the second half of 2011,” says “Downtown” Josh Brown, a New York wealth manager who blogs as the Reformed Broker. “So people are venturing away from the defensives and consumer staples and the utilities that kept them safe and now they want to play.”
Or perhaps the “risk-on” zeitgeist of early 2012 will prove to be short-lived and will give way to another round of “risk-off” fear, a la much of 2011 and 2008. Last summer’s global flight to safety gave U.S. Treasuries some of their best returns in history—debt downgrade be damned—and sent the market into a full-blown correction.
But so what, right? History never repeats itself.