by Jason Doiron
FRM, PRM, SVP - Head of Fixed Income & Derivatives
Sentinel Asset Management, Inc.
I estimate that I inadvertently watch 12 hours of financial news programming per day. Too much television? perhaps, but for a portfolio manager it has become an occupational necessity. One of the greatest benefits to watching this much television is that I can recite verbatim every commercial that plays on CNBC with no clue which company is sponsoring the ad - pig on a skateboard anyone? The other benefit is that I am provided with a front row seat to a rogues gallery of pundits who describe the complexities of the financial markets through sound bites.
After a close contest with "kick the can down the road" and "tail risk," the undisputed champion of sound bites since 2008 has been "risk-on / risk-off." Both terms accurately describe the market sentiment for certain periods over the past 3.5 years. But as with all good sound bites, the useful life span of these terms is quickly coming to an end. Before we bid farewell to these terms, let me explain my reasoning for predicting the demise of risk-on / risk-off.
1) Irrelevance:
No other term more accurately described the market sentiment in 4Q08 and 1Q09 than risk-off. During the summer of 2011, the term risk-off accurately described the sentiment in certain sectors of the fixed income market such as CMBS. But the term risk-off does not accurately describe a 2 point sell-off in the SPX [1] on a Thursday afternoon before a 3 day weekend in July. That is simply called a pull back.
2) Professional:
I can assure you that the terms risk-on and risk-off did not originate from anyone in the risk management profession. Risk management professionals do not reduce an opportunity set down to a binary outcome such as on/off. If a true risk management professional were trying to describe the risk on/off phenomenon, they would use a term like homoscedasticity.
3) Fundamentals:
The demise of the term risk-on / risk-off should be a welcomed event by investors. Over the past three years, the only question that investors have needed to get right is risk-on or risk-off. Investing became a binary outcome where the instruments that you utilized to express either of these views mattered little as long as you got the on / off call correct. This seems easy enough but in a homoscedastic world, the benefits of diversification will prove to be futile in your fight against the risk on / off mentality.
We are starting to see an investment landscape where fundamentals matter again. A landscape where securities derive their value from the fundamental underpinnings rather than from a headline on failed votes regarding debt ceiling limits or sovereign default write-downs. The pundits will need a new sound bite to succinctly describe this landscape so I offer up. Heteroscedasticity!
Sources: Sentinel Asset Management
[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
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