Fear and Complacency

Fear and Complacency: "Free Diving" Isn't Free
by Eric J. Fry
The Rude Awakening
Wall Street, New York
Tuesday, February 7, 2006

Eric Fry notices and wonders about the low levels of Fear and the high Complacency present in the markets.

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Joel Bowman, reporting from New York, a world away from the
warm waters of Indonesia...

When you take off on a wave over a reef break, there exists
a kind of caution in your action that is totally absent
when paddling into a wave over a sand break. It is not just
the difference in the formation of the wave, more the
difference in what happens to you if you fall off and hit
what's underneath it. The scrapes and bumps of a sand
wipeout are nothing compared to being torn up by jagged
reef.

Everyone remembers the first time they graduate to a reef
break as a young surfer. There is a rush of excitement
fueled by the knowledge that danger lurks but a few feet
below your speeding board.

Even clearer than the memory of your first surf over reef
is the first time you actually hit it's razor edges...

My first scare occurred on a surf trip with my dad in
Indonesia when I was ten years old. I had been growing more
and more confident in the water, paddling onto larger waves
and taking off further inside, where the face of the wave
is steeper and the risk of coming unstuck is greater.
After a few hours in the water I felt it was time to take
on one of the larger "set" waves. As soon as I felt the
power of the larger wave beneath my board, I knew I was in
over my head. Suddenly, the reef below the glistening
Balinese water didn't look so peaceful.

Luckily, I landed on my side and not head first into the
coral. There was a bit of bark missing off the ribs and
arms but nothing too major. Certainly, it would be some
time before I left the relative safety of the deeper water
to paddle in over the shallow part of the reef for another
set wave.

If you haven't hit rock (or reef) bottom in a while, it can
be tempting to take a little more risk than you would
usually allow yourself to wager. Below, Eric takes a look
at the investment waters. The surface may appear to be
relatively calm, but what's underneath is razor sharp and
the swells are rising...

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"Free Diving" Isn't Free
By Eric J. Fry

On October 12, 2002, a beautiful, 28-year old French woman
named Audrey Mestre attempted a record-setting "no limits"
free dive to a depth of 561 feet. She succeeded in diving
to 561 feet, but not in re-surfacing alive. Today, many
investors are diving headlong into high-risk stocks and
bonds...and we would not be surprised if these "no limits"
investment plunges also end badly.

When bi-pedal, oxygen-breathing mammals descend 500-feet
below the surface of the sea on a single breath of air, bad
things can happen. And bad things can also happen when
greedy or naïve mammals descend into the murky depths of
high-risk securities.

We would readily admit that "buying risk" has paid off
nicely for the past couple of years. In fact, in several
past editions of the Rude Awakening we had suggested buying
the stocks and bonds of countries like Russia and Brazil.
We have not abandoned our long-term faith in these two
economies. But, in general, we think the time is fast-
approaching to "sell risk," rather than to buy it.

Since the dawn of the new millennium, risky assets like
emerging markets stocks and bonds, U.S. junk bonds and U.S.
small caps have greatly outdistanced their less-risky
counterparts. Over the past three years, for example, the
S&P 500 has gained a respectable 50%. But over the same
time-frame, the Russell 2000 Index of small-cap stocks has
doubled, and the Morgan Stanley Index of emerging market
stocks has tripled.

Fear and Complacency: Fear Bear Market

Risk-taking has also excelled in the global bond markets.
Debt securities from traditionally high-risk borrowers like
Russia and Brazil have racked up enviable returns, while
U.S. Treasurys have produced almost no return at all. As
these various risky assets have dazzled and amazed, the
perception of risk in the capital markets has dwindled to
almost nothing. You could say, therefore, that fear is in a
bear market.

"You can almost see it in the marketplace," observes James
Grant, editor of Grant's Interest Rate Observer. "Stock-
market volatility, as measured by the VIX Index, is at 10-
year lows.  Credit spreads – investment-grade, speculative-
grade, emerging market, etc. – are hugely compressed. 
Observing the levels, one would almost suppose that the
nation was at peace, the yield curve was positively sloped,
the H5N1 strain of bird flu had been eradicated and the
chairmanship of the Federal Reserve Board was not changing
hands..."

One might also suppose that Iran had decided to build
tractors, instead of reactors...or that the suicide-bombing
terrorist groups of the Middle East had taken up new
hobbies, like quilting and stamp-collecting.

But the modern-day world does not feature such blissful and
serene conditions, as evidenced by the array of anti-
terrorist squads and NYPD K-9 units that continuously
patrol the streets of Wall and Broad, just outside your
editor's office window.

 Curiously, Grant notes, "theses echoes of September 11 do
not penetrate the financial district office towers. Inside,
computer screens trace out the lows in stock-market
volatility and bargain-basement prices in credit default
swaps."

In other words, most professional market participants are
fearless – or complacent – or fearless and complacent,
which amounts to a kind of recklessness. Not only do they
fear no evil within the financial markets, but they eagerly
sell insurance against it.  For example, many hedge funds
have embraced the business of "writing insurance" against
credit defaults – a practice known as selling credit-
default swaps.

Fear and Complacency: Very, Very High Complacency

If the mere mention of "credit default swaps" perplexes
you, or causes your eyes to glaze over, don't worry about
it. (Your editor only pretends to like this stuff). The
essential thing to understand is that these swaps
illustrate the price of insurance in the bond market, and
therefore, the level of fear or complacency that investors
are exhibiting. At the moment, swap prices are very, very
low, which means that fear is also very, very low...and
complacency is very, very high. (That's rarely a good
thing).

Default swaps on Russian government debt, for example, have
tumbled to record-low levels. Ten years of insurance
against a Russian credit default costs a mere 84 basis
points. For perspective, as recently as 2001, Russian
credit-default swaps cost ten times as much. But back then,
the memory of the 1998 Russian credit-default was fresh in
the minds of investors, as was the Asian currency crisis of
1997, the Brazilian crisis of 1999 and the Argentinean
crisis of 2001. But because the years since 2001 failed to
produce a noteworthy financial crisis, bond market
participants have learned to turn a blind eye to risk.

"Brazil's borrowing costs dropped to a record low earlier
this month," Bloomberg News reports, "Investors demand
[only] 2.95 percentage points more yield to hold Brazil's
12.25 percent bond due 2030 instead of a U.S. Treasury of
comparable maturity, down from 4.48 percentage points in
October...Russia's dollar-denominated bonds yield an
average of 1.13 percentage points more than U.S. Treasury's
with a couple maturity..."

The U.S. stock market displays a similarly striking absence
of fear. The VIX Index of implied option volatility
languishes near all-time lows. Because the VIX is based on
real-time option prices, it reflects investors' consensus
view of future expected stock market volatility. "During
periods of financial stress, which are often accompanied by
steep market declines," the CBOE Website explains, "option
prices - and VIX - tend to rise. The greater the fear, the
higher the VIX level. As investor fear subsides, option
prices tend to decline, which in turn causes VIX to
decline.

Fear and Complacency:  The Balance Between Risk and Reward

Eighteen months ago, buying risk seemed like a decent idea.
In several editions of the Rude Awakening, for example, we
extolled the virtues of Brazilian and Russian stocks and
bonds. Twelve months ago, we still loved these markets.
Nine months ago, we still liked them a whole bunch. But we
like them less now...at least for the short-term. The
balance between risk and reward has shifted dramatically
away from the buyers of risky assets to the sellers of
them. Most risky assets are simply offering too small a
return in exchange for the hazards they impose.

So while there may be no urgency to sell high-risk assets,
we would not argue with the idea. Although the perception
of risk protection in the financial markets has fizzled,
risk itself remains.  It never disappears completely, even
if it does sometimes take lengthy sabbaticals.  And the
presence of risk in the marketplace – both geopolitical and
financial - poses ever greater potency and risk, due to the
fact that so many investors have been increasing their
exposure to it.

"Professional investors could protect themselves by buying
a portfolio of credit default swaps or an index on stock-
price volatility," Grant advises. "Amateurs could lay in
Treasury bills."

Aggressive amateurs could seek to profit from the return to
rising risk awareness – and the commensurate rise in risk
premiums – by investing in a fund like Access Flex Bear
High Yield Fund. This innovative mutual fund, according to
its Website, "seeks to provide inverse (opposite) exposure
to the overall high yield market. That means that unlike
traditional high yield mutual funds, Access Flex Bear High
Yield Fund generally should increase in value when the high
yield market falls—and generally should decrease in value
when the high yield market rallies."

Interestingly, ProFund's Access Flex Bear High Yield
(AFBIX) buys credit-default swaps to gain positive returns
as junk-bond indexes plunge.

Maybe that's a plunge worth taking...from the short side.

[Joel's Note: Even sectors that are enjoying a major bull
trend are becoming extremely volatile of late. One need
only look as far as the commodities and the massive price
swings of sugar. This is bad news for anyone who suffers
from motion sickness...and great news for Kevin Kerr. This
man thrives in a volatile market and he can help you
navigate your way to the massive profits that such a
climate can yield. Learn how to have Kevin make money for
you right here:

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And the Markets...

	Monday	Friday	This week	Year-to-Date
DOW	10,798	10,794	5	0.8%
S&P	1,265	1,264	1	1.3%
NASDAQ	2,259	2,263	-4	2.4%
10-year Treasury	4.54	4.53	1.00	14.00
30-year Treasury	4.62	4.63	-1.00	8.00
Russell 2000	728	724	4	8.1%
Gold	$569.80	$568.90	$0.90	10.2%
Silver	$9.73	$9.74	-$0.01	10.3%
CRB	343.25	345.90	-2.65	3.4%
WTI NYMEX CRUDE	$65.02	$65.37	-$0.35	6.5%
Yen (YEN/USD)	JPY 119.02	JPY 118.86	-0.16	-0.9%
Dollar (USD/EUR)	$1.1964	$1.2022	58	-1.1%
Dollar (USD/GBP)	$1.7476	$1.7621	145	-1.6%