Home Forex Three main indicators to assess the 2024 risk balance

Three main indicators to assess the 2024 risk balance

by SuperiorInvest

I am a risk manager, both literally and figuratively. Literally, whether it’s with our own funds and strategies or allocations to individual investor clients, or with my trading portfolio when I worked on Wall Street, hard limitations are always capital, capitaland capital So managing risk is part of making sure you don’t lose that capital.

But also figuratively: My natural disposition is conservative, which is why I’m a bond guy (worried about getting my original investment back at par, in the end) rather than a stock guy (full of dreams of a 10-pound stock market). because I’m not the first to realize that Blockbuster Video is going to revolutionize video rentals and I’m not that worried about how it will disappear almost overnight on Netflix).

So when I look at the investment landscape, I generally don’t focus much on “what I think is going to happen”; rather I spend more time thinking about the variety of possible things that could happen and their relative probabilities.

In theory, all rational investors do this, but markets don’t operate like this. For example, currently trading at $72.60 does not appear to give any weight to the possibility of a hot war in the Middle East that could abruptly spike prices to $125 a barrel or higher.

That is not a prediction that there will be a conflict that disrupts oil production or distribution (which, since there is already a conflict—although it has not affected oil production and only marginally affected distribution—does not seem like the kind of conflict small risk (possibility that we can ignore), but simply an observation. If you think there is even a 10% chance of oil going up $50 a barrel, it would be worth $5 a barrel.

“But Mike,” you say, “maybe that’s already in the price, and if it weren’t for that possibility, oil would be $5 lower?”

Well, the risk manager in me is looking for confirmation that the market is at least a little nervous, and with oil trading at its long-term average and well below the post-2020 peak average, I find it difficult characterize the Energy markets are “nervous.”

OVX Index - Weekly Chart

Anyway, this is why I don’t like year-end “outlooks” and why when I forecast the CPI for a year or two I almost always focus on a range of likely outcomes rather than an estimate. punctual.

Honestly, we should all do this, but not enough people have studied enough statistics to understand the meaning of error bars. If you have an experimental mean and a nice big error bar, it means that you can’t reject the possibility that the true mean is anywhere in the range covered by the error bar.

So when someone introduces a new rental index that is supposedly more current but, by their own admission, has 15 times the standard error, I ignore it.

Rent inflation measures

Rent inflation measures

Enough of the preliminaries. Let me continue with this. Here are my thoughts on balancing risks for some important elements:

1. Interest rates

The balance of risks is clearly greater.

This was even more true at the end of the year. But with rates at 4.11%, down from 5% in October, keep in mind there are two ways to get there. lower Interest rates are already priced in: The short end of the curve reflects expectations (despite protests by Federal Reserve officials to the contrary) of approximately 150 basis points of cuts in the official overnight interest rate this year, and the long end reflects inflation expectations of just 2.27%. in the next 5 years and only 2.30% inflation in the next decade.

In addition to this, consider that with the trade deficit decreasing but the budget deficit No declining, more of the budget deficit will have to be financed by domestic savings, and the Federal Reserve continues to reduce its balance sheet, so it is pushing in the opposite direction. The balance of risks in the bond market is towards higher rates.

GT 10 Government Annual Chart

2. Stock market

The balance of risks is lower, with the exception that the outlook is much better if the market is analyzed excluding the fashionable stocks of the ‘Magnificent 7’ (Apple (NASDAQ:), Nvidia (NASDAQ:), Meta (NASDAQ: ), Tesla (NASDAQ:), Amazon (NASDAQ:), Microsoft (NASDAQ:) and Google (NASDAQ:)).

The S&P currently has a P/E of 21.4 and is up 24% since the end of 2022. The S&P ex-Mag7 has a P/E of 18.4 and is up 11% since the end of 2022. The S&P themselves Magnificent 7 has a P/E of 39.5 and is up 110% over the last year.

UBXXSPX7-Daily Chart

The overall market P/E doesn’t seem so bad until you remember that this is only because profit margins are currently only a little below their highs in at least 30 years (and probably much longer; this is so back as Bloomberg has been for 12 years). months of margin).

The balance of risks is definitely in favor of lower margins, which means lower profits, which means the same stock prices would represent higher P/Es. Oh, and what happened to those people who said high stock prices were due to really low interest rates? I haven’t heard from them in a while.

S&P 500 Profit Margin Monthly Chart

S&P 500 Profit Margin Monthly Chart

When I have clients who are long stocks, they do so in equal-weighted indices to reduce exposure to the Magnificent 7. But even if those stocks were the only ones overvalued, it’s unreasonable to think they could come back to earth. and not bring down the rest of the market.

If Apple, Nvidia, Meta and Microsoft fall 30%, the rest of the market will not rise. However, if such a thing were to happen, the market outside of the Mag 7 could eventually come to look cheap.

3. Credit spreads

The balance of risks is broader, with the 10-year Baa credit spread near 30-year lows. Seriously, how low does this go? And the queues are obviously one-way.

BICLB10Y-Monthly Chart

That’s why I’ve said that the balance of risks favors higher interest rates, wider credit spreads, lower corporate margins, and lower stock prices. It is also helpful to think about where the risks are in my risk assessments. If we get lower, rather than higher, interest rates, then it will most likely be because the economy is much weaker than it currently is, and the Fed ends up having to ease. further of 150 bp in 2024.

That seems unlikely to me, but if it happens then note that it probably also This means that credit spreads will widen and companies’ margins, profits and stock prices will decline. So if you’re bullish on bonds and actions, it seems to me that you are taking a dangerously narrow path. To me, the risk balance looks bearish on both sides, but the bullish outcome for bonds implies (I think) a bearish outcome for stocks. It is difficult for me to see an environment with appreciably higher stocks and bonds unless the Federal Reserve pursues aggressive monetary policies without any economic weakness. So that’s your implicit bet.

On the other hand, being bearish on both stocks and bonds does not carry such a narrow path risk. Unless the Federal Reserve eases although In a strong economy, it’s not hard to imagine an environment with lower stocks and bonds. Hell, we had that vibe a few months ago, before the ‘pivot’. It is not a scope.

Bottom line

None of the above is a forecast. But investing and trading are about evaluating the range of risks and trying to take positions with asymmetric risk-adjusted returns. In my opinion, long investors should go short the yield curve (and increase credit, and linked to inflation rather than nominal) and weight their stock holdings against the cap.

That’s the closest thing to an outlook article I’m doing this year. Have fun.

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