BULLS & BEARS: Investors overlooking risk, and that spells trouble

I closed my last column by suggesting that the markets seem to be paying little attention to risk across a broad range of asset classes.

One measure of risk is stock market volatility, or the magnitude of ups and downs in stock prices. The Wall Street Journal recently reported the following statistics compiled by the market analysts at Ned Davis Research: It has been almost 1,000 trading days since the Dow Jones industrial average has seen a 10-percent decline from a high, the second-longest run on record.

In addition, the Dow has gone 140 trading days without a 2-percent decline, the longest stretch since 1958. With volatility near a record low, would it be prudent to assume that some time in the future, stock prices will become more erratic?

Risk appears to be absent in the junk bond market. Throughout 2006, junk bonds (also called high-yield bonds) experienced a record-low default rate of 0.8 percent. This is in contrast to a longterm average default rate of 5 percent, with default meaning the issuer of the bond was unable to pay the interest due.

To compensate for their higher risk, junk bonds pay higher yields. Yet in 2006, investors in junk bonds were paid only 2.7 percent more than a risk-free Treasury bond versus a historical rate of 5.2 percent above Treasuries. Could one conclude that default rates eventually will rise and that buyers of junk bonds today are not being adequately compensated for this risk?

Much of the market’s benign attitude toward risk can be attributed to the lowinterest-rate environment and an economy that is humming along at a pretty good pace. But one wonders whether the markets and investors have become too complacent. Looking around, there is certainly plenty of evidence that risk is present.

For example, private equity firms have borrowed massive amounts of money via subprime loans and junk bonds to finance their acquisitions. Hedge funds have borrowed large sums from investment banks to leverage up their portfolios-one large hedge fund recently disclosed it has borrowed $12 for every $1 in its fund. While leverage boosts returns on the upside, it also magnifies losses on the downside.

Are excesses forming in commercial real estate? Currently, there is a bidding war for the nation’s largest publicly traded real estate investment trust, Equity Office Properties. The price tag, $39 billion, is 15 percent above the first offer made for the company. Why is Sam Zell, the magnate behind Equity Office and one of history’s sharpest commercial real estate investors, selling? Could the winner of this deal also be the loser in the long run, by overpaying for the properties?

Last, when you see hedge funds tripping over themselves to pay more than $200 per square foot for office space in the toniest sections of London’s financial district, you have to step back and conclude this is not sustainable.

Risk may be in hibernation, but it has not gone away. And when it comes out of its slumber, how will the markets react? For investors, like ourselves, who are struggling to find attractive values, the nearly 5-percent return on liquid risk-free investments is not a bad alternative while you wait.