BULLS & BEARS: Awareness of risk is back, and that’s not a bad thing

“I’m baaack!” yelled Mr. Risk at the top of his lungs on Feb. 27.

“Welcome back, Mr. Risk. You have been gone a while,” responded a nervous Mr. Market. “Even though deep down we knew you were hanging around the neighborhood, we had forgotten all about you.”

And thus ended the calm that had presided over the stock market, which had risen in regimented fashion the past seven months. With the 416-point drop in the Dow Jones industrial average that day, the stock market morphed from its placid mood into anxiety. One of Wall Street’s measures of risk, the “volatility index,” or VIX, jumped an incredible 70 percent. Even then, it is at a level below its long-term average.

Of course, the media seized on the market’s dive with “breaking news” reports and a parade of “expert analysis.” The 3.3-percent decline in our stock market was attributed to the 9-percent drop in the Chinese stock market the prior night. And while that might have been the trigger that brought risk consideration back into the investment equation, there had been indications the markets had been ignoring some of the risks lurking in the shadows.

Consumers and investors already were well aware that the residential real estate market had slowed considerably. And since the first of the year, news had been leaking out that some of the subprime mortgage lenders were facing substantial losses. Perhaps it’s no surprise that, at the peak of home-buying frenzy, these lenders were freely making loans to buyers with marginal qualifications. The market’s newfound appreciation for risk has sent the subprime corner of the investment world into a meltdown.

And, there is heightened concern over hedge fund exposure to the “yen carry trade.” This involves borrowing money in Japan, at say 0.5 percent, and reinvesting the loan in a higher-yielding market, such as the United States’, at, say, 4.5 percent. This is a lucrative investment, which is why there are huge sums of money playing this interest-rate discrepancy.

Yet because there is massive leverage employed in the carry trade, a change in one of the variables can lead to crushing losses. For example, if the value of the dollar weakens against the yen, it suddenly takes more dollars to pay off the Japanese loan. And when you have $10 worth of yen borrowed for every $1 of equity in the trade, it doesn’t take much change to turn profits into losses. Wise investors are aware of the systemic risk to the markets were the yen carry trade to unwind due to a market adjustment. If all the players were to head to the exit at once, they would not find many doors open.

So risk awareness is back, and that’s not a bad thing. The low level of interest rates and the massive amount of liquidity in global markets has allowed investors to leverage all sorts of financial assets, including loans, derivatives, commodities, real estate and stocks.

Depending on which media expert is talking, this is either the beginning of a terrible bear market or the buying opportunity of a lifetime-so far, we think it is neither. One potential benefit is that the return of market volatility often leads to mispriced business valuations and thus may offer up a few attractive investment opportunities for patient long-term investors.