GUEST
COLUMN
Lack of market volatility in recent
years has led to a general complacen-
cy in the investing community. With
rising stock prices, falling bond yields
and buoyant commodity prices, are
you underestimating financial market
risks and misallocating resources?
Common risk measures assume
that stock prices rise and fall with
equal amplitude. Yet experience
shows markets rise in slow, steady
fashion and fall with greater intensity
and speed. In other words, volatility
rises in market corrections.
Since financial markets bottomed
in April 2003, we’ve witnessed one
of the longest uninterrupted market
rises on record. As a result, volatil-
ity has been in steady decline. The
CBOE Volatility Index has been run-
ning a shade higher than 10 in recent
months, well below its average of 19
dating back to 1990. (See charts,
page 48.)
If the typical trade-off for inves-
tors is one of risk and return, you
wouldn’t know it based on the returns
investors have been receiving. Since
April 2003, the only loser has been a
dedicated short strategy. Everything
else has gone up, from less risky bond
investments to high-yield debt and
domestic equities, to the edges of
risk in emerging market equities and
commodities.
However, this Goldilocks envi-
ronment is leading to distortions in
46 advisor’s edge | may 2007 www.advisor.ca
the comfort trap
Are advisors ignoring market risk?
asset prices. Across risky asset mar-
kets, risk premiums generally de-
creased due to investors judging these
markets as safer.
History tells us that financial mar-
kets are risky, that volatility rises in
declining markets, and that investors
demand higher returns to compensate
for the greater risk of an asset class.
Credit Cycle
So what exactly is happening to secu-
rities markets and why is risk being
priced so cheaply? The fact is we are
in the midst of a credit bubble.
The bubble has its roots in the
technology stock mania of the 1990s.
When it burst, U.S. Federal Reserve
chair Alan Greenspan administered
life support. The Fed cut interest rates
aggressively to 1% to stave off the
deemed risk of deflation. That move
proved just the tonic for the flagging
economy and set in motion the lon-
gest string of double-digit quarterly
increases in corporate profits (which
ended at 14 consecutive quarters at
the end of 2006).
While low rates were good for the
economy and corporate profits, much
of the success was premised on the
U.S. consumer taking on more debt
personally and on the U.S. economy
taking on more debt globally.
The housing boom was inflated
by easy access to credit and by run-
ning a massive trade deficit, while
By Levi Folk
the U.S. essentially exported a credit
bubble overseas. For every dollar that
flowed to China to purchase Chinese
exports, the People’s Bank of China
(PBoC) has resisted currency appre-
ciation by buying dollars and selling
its currency, the yuan. This has in-
creased its money supply and eased
credit conditions in China.
One good turn deserves another
in the case of those dollar reserves
held by the PBoC, which have found
their way back to the U.S. via the
bond market. The trillion dollars of
reserves represent part of China’s net
savings, which have been used to buy
U.S. treasury securities.
Hence the global savings glut is
pushing down U.S. bond yields and
adding to the easy credit conditions
there. Add in the zero-interest rate
policy put in place by the Bank of
Japan to stave off an actual bout of
deflation, and investors have been able
to borrow money cheaply and invest it
in what are traditionally risky markets.
It’s no wonder volatility has de-
scended to multi-year lows. Inex-
pensive credit is fuelling economic
momentum, which is emboldening
investors to commit ever-greater sums
of capital to equity and bond markets.
If you want proof, look no further
than yield spreads on risky bonds.
The yield spread is the extra returns
charged by lenders on risky securi-
Continued on page 48
GUEST
COLUMN
Continued from page 46 higher and debt financing may have are very high. Economies are much
ties over U.S. government treasuries. increased but not as a percentage healthier now than in the 1990s.
It was as high as 10% on emerging of corporate net worth. Companies These better fundamentals suggest
market debt and junk bonds in the have been buying back stock and that any recession could be more shal-
1990s and is now below 300 basis paying cash to shareholders by way low than normal because of fewer ex-
points for both. of dividends. Capital overspending is cesses to work off. But the suggestion
Some of that difference is justi- not a problem. that business cycles are no longer rel-
fied by better fundamentals here and In the emerging markets, debt levels evant for pricing risk is ludicrous.
abroad. Corporate balance sheets are are lower, inflation is generally under Global economic prosperity sits
definitely improved. Earnings are control and foreign exchange reserves perched on the knife edge of the
U.S. consumer, due to the increased
trade and capital flows of globaliza-
roller coaster reduction tion. Therefore, the diversification
United States, CBOE, Volatility Index, Close, USD
benefits of investing in overseas
markets and alternative asset classes
50 are greatly diminished.
45 Consider how a U.S. recession
Mean
40 would reduce trade with China and
35 affect the stock markets of East Asia.
30 Further along the chain, commodity
Per cent

25 markets would get hit by slower eco-

20 nomic growth in the U.S., and com-
15
modity exporters would also suffer.
10
In fact, there would be few places for
you to find refuge for your clients.
5
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 The credit cycle has already turned
Source: Reuters EcoWin in the U.S. housing market. While
credit may be ample in the rest of
the economy, it has withered away
benign bonds in the mortgage market. After being
United States, Corporate Benchmarks, Yield Spread lured into adjustable-rate mortgages
when the Fed Funds rate was at 1%
3.5 in 2003, new home owners are now
reckoning with mortgage payments
3.0
that are resetting and being priced
2.5 BBB bonds off a Fed Funds rate of 5.25%. The
result has been devastating.
2.0
Record housing price gains have
Per cent

1.5 been followed by a depression in hous-

1.0
ing sales. Housing starts and building
permits are off nearly 30% from Feb-
0.5 ruary 2007 over the same month from
0.0 the previous year, and delinquency
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr and default rates are on the rise. The
03 04 05 06 07
risks of this crisis spreading to other
Source: Reuters EcoWin parts of the real economy loom large.

48 advisor’s edge | may 2007 www.advisor.ca

 With these points in mind, consider the risk-versus-
reward trade-off when investing in the various markets
and asset classes at present. The added risk of owning
high-yield debt is likely not adequately compensated for
with only 300 basis points of additional yield annually
over lock-safe government debt. On a $50,000 alloca-
tion the difference is only $1,500 per year.
Emerging market equities in East Asia have performed
admirably, and they may rise further, but they are a lev-
eraged play on the U.S. stock market. Fundamentals are
better than in the U.S. in many cases, but if the U.S.
economy is slowing, those stock markets are likely to
underperform U.S. equities.
As the credit bubble continues to unwind, borrow-
FUNDWRAPFILTER &
ing costs will rise beyond the housing market. This will ASSETALLOCATIONFILTER
obviously have repercussions for highly leveraged invest-
ments. Private equity deals will dry up and small-growth
companies more reliant on debt financing will get hit
the hardest.
The safest place to invest is in large capitalization MORE HANDS.
companies with strong balance sheets, consistently
growing dividends and stable earnings. These companies
MORE HANDS ON.
are not highly valued because they have fewer growth One program—two free tools—to
prospects than the smaller, more dynamic companies on filter, sort and streamline asset
the developed economy exchanges. But that makes them allocation and fund wrap programs.
safer bets in a market where liquidity is drying up. Get your hands on these tools now
Japanese stocks may be another smart place to in- at advisor.ca
vest should liquidity start to vanish. The Japanese yen
is highly undervalued due to the absolutely low level of
interest rates in Japan in recent years. Domestic investors
have been sending money outside of Japan in search of
higher yields, and the falling yen has encouraged that
strategy. But as the economy improves, interest rates will
rise and money will flow back into Japan. Therefore,
investors would benefit from the twin tailwinds of an
improving stock market and rising currency.
We have been witness to an unprecedented boom
in equity, bond and commodity prices the world over.
These gains are, to a large extent, based on unusually
easy credit conditions. Eventually, they will revert to
more normal levels, and those advisors who anticipat-
ed and prepared for this on behalf of their clients will PARTNERS
avoid significant pain.

Levi Folk is president of Generation Capital and the Fund Library,

an investor research website. advisorsedge@rmpublishing.com

www.advisor.ca advisor’s edge | may 2007 49