Has Insane Risk-Taking Disappeared in the Investing World?
With the Dow having lost nearly 50% of its value since its highs in 2007 and panic being present all over the spectrum, one has to wonder if the insane risk-taking with a blind disregard for potentially negative consequences has disappeared from the investing world. Many have argued that people have now become extremely risk-averse and we have completely shifted orientation. Reading over investing websites such as this one (TMF), KaChing, SeekingAlpha, etc.; I am not so sure I agree with this analysis.
Much to the contrary, blind risk-taking hasn't disappeared at all; it's simply been modified. Like a foaming from-the-mouth Communist who becomes a diehard laissez-faire capitalist overnight, many investors have merely switched their team colors, but are still playing the same game as they were before.
People are buying treasury bonds in droves. I'm hearing people promoting BAC and C as great shorts. Others are buying gold on the belief that it will skyrocket to 10000/oz; and then others are shorting gold on the belief that it will fall to 500/oz (proof that perma-bears can disagree on the results!). Isn't all of this aggressive bearishness similiar to the aggressive bullishness that lead to the market becoming so overvalued to begin with? Isn't this the same mentality that drove housing prices through the roof despite the fact that people couldn't even afford to pay back the loans they were taking?
Risk-Reward Is Key
As previously alluded to, perhaps what made me realize this was the number of people I have heard who have recommended shorting C and BAC. Don't get me wrong --- both banks have a ton of junk on their balance sheets and both may very well be doomed. Maybe the odds for nationalization are even above 50% at this point despite the government's insistence that this is unlikely. But here's the thing ... how can one justify a short on BAC or C based on risk-reward principles?
When bank stocks and housing prices were at their highs, people weren't looking at fundamentals and thinking to themselves, "well, how much higher can these things realistically go? And how far can they drop?" Rather, you bought a home because it was a sure thing that the price would increase. And you bought that stock because it couldn't lose.
Back to my BAC and C examples --- there are really only two realistic possibilities; these stocks zero out after nationalization (or in the rare event the gov't lets them fail), or the banks survive and the stock prices likely shoots upwards. If you short BAC, you win 100% if you're right --- but more importantly, you end up losing somewhere in the 300-1000% range if you're wrong.
Is this a justified gamble based on risk-reward principles? Even if you believe the odds of BAC failing are 70%, it would not appear to me that shorting it right now would justify the risk of the negative result. In fact, unless you believe there is a 90-95%+ chance of it zeroing out, I'm not sure that it can be justified very well.
Just to compound things further --- let's consider what we're talking about here. We're talking about large cap bank stocks that the government has a heavy interest in seeing survive. This isn't some small cap manufacturing firm with a poor balance sheet that no one is going to bat an eyelash if it goes under. This is a Goliath and you never know how government action will affect the ultimate outcome --- therefore, there's even more uncertainty than usual. So to take a gamble on this given the odds and given the extreme uncertainty seems ... well ... very typical of the same behavior that leads to bubbles in the first place.
Can there be such thing as a reverse bubble? If you take a look at previous market crashes, it doesn't seem completely implausible. Capitulation events are normally quite dramatic and overshoot by a great deal. If you bought in at the bottom of the Great Depression in 1932, it wouldn't have taken you long to make some sizable returns.
The treasuries bubble is also intriguing to me because I look at the yields the bonds are paying right now and I have to question, what's the upside? Sure, bond prices could continue to go up a bit further, but they could plummet downwards a lot further than they can move upwards, especially if we see inflation again in 2010. Yet, what is driving bond buying is a false sense of certainty amongst investors that the market will stay down for an extended period of time (say 3-10 years). I'm not saying it can't happen; but I don't know that it's justified based on a reasonable risk-reward analysis. What if we get 10% inflation? Your money is basically be destroyed since your yields are nowhere in that range.
What's the Deal-io?
If you were to ask me, I personally believe we are in the midst of a final capitulation event. I am not a market timer, though, and I admit the market could continue to go down through June ... or even through the beginning of 2010. I have no clue. All I know is that looking at individual companies, analyzing their assets, equity, debt/liabilities, and cash flows --- I see a lot of firms that look significantly undervalued out there. So from my perspective, it makes little difference if we're in an extended recession; risk-reward says I should buy into equities with appealing prospects and limited downside.
I'm sure there are some brilliant market timers out there who will know precisely the moment when to switch, but I'll also bet that these people are rare exceptions to the rule and not the norm. The market could stay down for several years, but it could also go up 20-40% by 2010 given how depressed prices are right now. When I look at the fundamentals, I would be afraid to be overly bearish right now. In most cases, it would appear that risk-reward is not on the bears' side any more and maybe the "reverse-bubble" will collapse soon.
How I'm Playing it on CAPS
Admittedly, I'm braver on CAPS than I am in real-life. My real-life buys have mostly been limited to commodity producers/miners that have been beaten down severely (TIE, X, PAL, SWC). Here on CAPS, I'm starting to go thumbs down on some of the bearish ETFs out there. Even more frightening, I'm starting to green thumb some banks and even some REITs that look undervalued to me. In the short-term, I'm betting my CAPS score could suffer greatly; in the long-term, I think I'll come out ahead. At the very least, it appears to me that risk-reward is on my side.