Chronic MACRO unease—and its benefits for risk management
Chronic unease isn’t a pleasant thing to deal with. But it’s important for the management of risk.
You may wonder what this topic has to do with the burning oil rig. The connection is simple: British researchers have analyzed which oil rig managers have the fewest accidents. Complacent chief strategists aren’t very successful. Managers with “chronic unease” whose nature it is to suspect a risk behind every corner that could endanger the existence of the rig do significantly better. These managers aren’t always the life of the party, but those who rarely suffer total loss typically stay in the race the longest.
We don’t know of any comparable studies on capital markets. But the connection is obvious and certainly similar when risk management is of the essence rather than the laying on of hands with the statement that the cost savings of passive investments will fix everything—if you hang in until the grave.
Because we at Mellinckrodt suffer from “chronic macro unease,” we take the opportunity to familiarize you with the most important topics in this and in the next articles on stocks over the summer. Even though these topics don’t keep us up at night, they do hold the potential to keep us busy from the early morning.
Liquidity and hedging
Most people would probably agree with the first hypothesis that the policy of the central banks has caused the prices for investments to skyrocket. In addition, most people—after brief contemplation—agree with the second hypothesis as well: searching for the criterion of price alone doesn’t make much sense since most assets are already expensive. In addition to price, other aspects are important. For stocks, for example, it’s the probability that a company would survive a big global crisis and not have to file for bankruptcy.
Imagine, for a moment, what it would mean for you if the prices of all your investments dropped by 30%. The prices of your real estate, of your classic car but also of the government bond or the participation in a private equity fund. Not a pleasant idea. But experience has also shown that in times of a major crisis prices don’t all drop at the same time. It usually starts with the most liquid stock market investments, other asset classes follow later on, and whenever that happens, there’s a big crisis. Just because we have been spared from the corrections at the stock exchange spilling over to other investments in the past years, we shouldn’t develop a false sense of security.
When the party is over, things need to be broken down. And that’s like with a big bounce house. The air doesn’t escape everywhere at the same time but rather from one pillar first and then from the others. In 2008, for example, at first stock exchange markets showed intense corrections. Then other big institutional investors realized that the relative share of other asset classes in the portfolios had become too big. As a result, there was, for example, much pressure to sell real estate and private equity investments. The Partners Group from Switzerland launched new investment vehicles during the crisis to acquire private equity participation at the secondary market with large discounts.
Investors who weren’t forced to sell their investments in 2008 were pleased about the subsequently increasing value of their private equity participation. Those who jumped on during the crisis and were able to buy with discounts were even happier. The same was true for real estate.
Foreclosures—and their causes—are an unpopular topic. A crisis is major when a big number of people and institutions have to sell. Liquidity is scarce and those who are liquid in the crisis can “sell” their money at a big price. In other words: when everyone is selling, those who have money to buy get assets almost for free.
So far, so good. Another aspect is more important. How do you stay liquid when a major crisis can be identified by a lack of trust in the financial system? The short-term doubling of interest for Italian government bonds during the quarrel about the government formation gave us a brief taste. And whether it’s the right strategy to pull the money out of private banks and take it to the Sparkassen as was the case in 2008 remains to be seen. Steinbrück is no longer in office, and whether citizens will buy another “ATM guarantee” from Mrs. Merkel is questionable. It may very well be that you won’t want to maintain a fixed deposit account at any bank in the euro zone when the next recession hits. The pillow is no alternative. So now what?
Buy stock. What? That would be crazy. No, it’s not.
Stock is an asset just like real estate, a classic car or a watch. The real estate owner has a title from the title agency, the stockholder is protected by the law on deposits of securities and you’ve registered your classic car at the appropriate agency. The fixed deposit at the bank is a loan. Not from the bank but for the bank. And when the bank is in trouble, then just google what that cost in Cyprus: 50%. And that is applicable EU law. The 50% aren’t deducted from your stock. They may suffer in value, but they aren’t the property of the bank and, therefore, not part of the bankruptcy assets.
Stocks offer another benefit. You can either sell them or—better in a crisis—hold on to them and hedge. That works neither with classic cars nor with real estate. And it’s exactly this possibility of hedging through options and futures that make stocks so interesting in times of crisis. We’re happy to explain how that works. If you’re not interested in the details, just look at stock funds that don’t only pick stocks but that have also incorporated the service of a functional risk management into their strategy.
However, it’s important that you’re not too greedy. Great overperformance as cavalry captain of the smallest second-line stocks and, at the same time, a functional hedging. That only works in fairy tales. You should therefore make sure that the stock that you buy is realizable. Liquidity and the possibility of hedging are the flip sides of a coin.
In a major crisis the discounts for foreclosures are high. In addition, there are numerous bankruptcies because especially from small, growing companies the air escapes quicker than from the bounce house in your backyard. Then you get nothing, and the previous great performance is gone for good.