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Fear Of A ‘Black Swan’ Event Is Worse Than The Actual Event Itself, Study Shows

Originally posted on May 3, 2016 Are investors more frightened of freak market crashes than the reality of such crises? Sometimes fear of a freak, outlier event can be a lot worse than the event itself, at least when it comes to the markets. Most of us are aware of the now famous credit crisis book by Nassim Nicholas Taleb , “The Black Swan: The Impact of the Highly Improbable.” The central thesis of the book is of course that black swans , or freak market events, are more common than we expect in life, and in particular, in complex systems such as economics. The credit crisis was, therefore, no great surprise, and such crises can be expected to occur in one form or another on a fairly regular basis. Well, that was Taleb’s thesis. But it was also a thesis written at the height of negative market sentiment. Subsequent serious academic work reported by Bloomberg by William Goetzmann, Dasol Kim and Robert Shiller looked at 26 years of survey data to test Taleb’s thesis. They found that people consistently expect things such as stock market crashes and earthquakes to happen more frequently than they really do. In other words, there may be black swans out there, but more important perhaps than their occurrence is our exaggerated fear of their occurrence. There are indeed periods of irrational exuberance when we forget about the possibility of black swans. But certainly since the credit crisis , it seems that there has indeed been an exaggerated angst that has gripped the global investing community. It is as if the crisis was sufficiently intense that it set off a type of Post-Traumatic Stress Disorder among investors, leading to everyone seeing specters around every corner. This overarching sense of angst has had very significant effects since the credit crisis. Although there has been modest growth in gross domestic product in the United States ever since 2009, the recovery hasn’t felt like a recovery. We continue to suffer what economist Joseph Stiglitz calls the “great malaise,” a lack of those animal commercial spirits. Shiller himself sees this anxiety as driving this very low rate environment as most investors and banks keep the bulk of their assets in low-return fixed-income assets, which itself further lowers the yield on said assets. This has also driven excess regulation. No one can say that the credit crisis didn’t merit a significant re-think of various parts of the U.S. financial regulatory architecture. But it is now becoming equally clear that the Dodd-Frank Act was a behemoth of a piece of legislation, 848 pages long, most of it with half-baked concepts that were left to be developed over time by sub-legislation. Many now expect the very framework of large chunks of Dodd-Frank to require major re-engineering, given its excessively controlling and complex features. The idea, for example, of bank living wills was probably a non-starter from day one. The concept was that banks must put in place plans for their orderly wind down in the event of financial failure, ones that didn’t rely on government support. But this was immediately a bizarre exercise for all financial institutions because it involved making up totally theoretical failure scenarios, some concatenation of events that is unlikely to have any bearing on the actual features of any next crisis. After all how on Earth could we predict what that crisis will really entail? The Federal Deposit Insurance Corp. and the Federal Reserve made all the banks write their living wills twice, on the basis that they were too loosely drafted the first time, but more granularity here doesn’t solve the conceptual problem. The situations conceived are so hypothetical that these living will models are often the case of garbage in garbage out. In addition, for those institutions that matter – the systemically important financial institutions – living wills are a particularly absurd exercise because, by definition, these large financial institutions are simply not sustainable during periods of acute illiquidity without government support. It seems, in other words, that Dodd-Frank itself was premised on their being black swans everywhere. And the capital requirements it imposes on banks, the compliance burden, the business line restrictions and high levels of liquidity buffers all mean that banks simply haven’t been meeting much of even the legitimate credit demand in the United States. The result, of course, has been huge growth since the crisis of the shadow lending market, which is legitimate lending done by non-depositary institutions. The shadow lending market has gone through a total re-birth since the crisis, as multiple research papers demonstrate. There can be dangers of an excessively large non-bank lending sector, but again Dodd-Frank has embedded within it another mechanism for seeing black swans in this sector also. That is the Consumer Financial Protection Bureau . The role of the CFPB in supposedly protecting borrowers from predatory lending is only just being defined now by the regulator. But there is already considerable confusion about the CFPB’s ambit, and, indeed, even a recent court hearing indicated that the bureau may be acting outside the scope of the Constitution. Meanwhile, the U.S. economy struggles to get above 2% GDP per annum, consumer inflation is negligible and growth is so anemic that the Fed’s attempt to raise short rates and normalize monetary policy is materially struggling. So it is back to Shiller and Stiglitz, just too much fear in the system to allow growth really to ignite. And so what does such economic neurosis really amount to? It isn’t necessarily the product of there being too many black swans but the product of an irrational belief that there may be too many black swans. And the big question then is when will it all end? When does the anxiety end, when is the neurosis cured and how? Disclosure: Jeremy Josse is the author of Dinosaur Derivatives and Other Trades , an alternative take on financial philosophy and theory (published by Wiley & Co). He is also a managing director and head of the financial institutions group at Sterne Agee CRT in New York. Josse is a visiting researcher in finance at Sy Syms business school in New York. The views and opinions expressed herein are those of the author and don’t necessarily reflect the views of CRT Capital Group, its affiliates or its employees. Josse has no position in the stocks mentioned in this article.

Lookin’ For Yield In All The Right Places

In a world of low and in some cases negative interest rates, investors continue to struggle to find yield. As such, they still find themselves in an all too familiar place: Accept less income, or take on more risk in the search for yield. But with global growth still sluggish and bond and stock prices looking expensive, balancing income and risk is more important (and challenging) than ever. The question for investors isn’t “Where can I go for yield?” It is: “In this environment, where can I find meaningful yield without taking on significant or unknown risk? ” There is a bit of a balancing act between yield and risk. Let’s take a look at how it can be done in three areas of opportunities for investors seeking income today. Fixed income Bonds or fixed income essentially play two roles in a portfolio: They offer yield or income, as well as potential diversification benefits as a sort of ballast to counter equity risks. Bonds run the gamut of risk and income. Short-term Treasuries offer the lowest default risk and generally the lowest yield, while high yield bonds typically offer considerably higher yields, but with significantly more risk. These two investments are quite different, but both can play a crucial role in a portfolio. However, the yields of Treasuries are paltry while credit instruments like high yield bonds exhibit equity-like risk, albeit with potentially higher yields. For investors looking to balance yield AND risk, risk-adjusted returns are important. That’s where municipal bonds come in. Municipal bonds aren’t an exciting topic over a cocktail party, however they were one of the best performing bond categories in 2015. According to Bloomberg data on the S&P AMT-Free National Municipal Bond Index, munis returned 3.3 percent in 2015, beating taxable investment grade bonds. This year, munis remain one of the highest sources of yield on a risk-adjusted basis. The sector’s tax-exempt status is another plus, and munis are a portfolio diversifier, with negative correlations to equities and high yield, our analysis shows. Other parts of the fixed income market have experienced volatility recently due to energy exposure or anticipation of Federal Reserve (Fed) moves, but the municipal bond market has been relatively stable. This may surprise some given the recent default announcement of Puerto Rican debt, which is a vivid reminder of why it’s important for investors to be completely aware of what they own and the risk they take in search of yield. (iShares ETFs are not impacted directly by the default, as none hold bonds issued by any U.S. territories, such as Puerto Rico or Guam.) Equity income If you prefer equity-like risk to come from equities in your search for yield, dividend stocks are a logical place to look. But it is important to remember that not all dividend stocks are created equal. As I’ve written before, my preference is for the segment of the market known as “dividend growers,” which as the name implies, are companies with a history of increasing dividends. There are some conditions – and clear distinctions – that may set dividend growers apart from other dividend stocks in today’s market, particularly their attractive valuations, stable earnings and stronger balance sheets. Somewhere in between Finally, there is an often overlooked option for investors looking to balance risk and yield: preferred stocks. Preferreds are income-generating securities that have both stock and bond characteristics. When it comes to risk, they’re somewhere in the middle of the spectrum. Similar to a bond’s coupon payment, preferred stocks pay fixed or floating dividends. They can appreciate in value like a common stock, but they’re not as volatile. Some question if preferred stocks will remain an attractive asset class in a rising rate environment. But since we expect the Fed to continue its dovish stance and rate rises to be gradual, we wouldn’t expect to see big downward spikes in preferred prices. Preferred stocks may also be attractive in this environment due to the fact that they’re issued mainly by financial companies, like banks, where net interest margins generally show improvement. Also, see what my colleague Russ Koesterich has to say on preferreds. Investors looking to balance risk and income while searching for yield may want to consider the iShares National AMT-Free Municipal Bond Fund (NYSEARCA: MUB ), the iShares Core Dividend Growth ETF (NYSEARCA: DGRO ) and the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ). This post originally appeared on the BlackRock Blog.

A Distinctly Canadian View Of Emerging Markets

Figuring out whether developed equity markets will outperform emerging market stocks has been no easy task, even if the choices couldn’t be any starker. By now, we are all familiar with the potential benefits of emerging markets: They have grown at a faster pace than developed economies, their population is younger , and they will soon be expected to aspire to consume many of the things people in the developed world take for granted. Sounds pretty good, right? Not so fast. These seeming positives have been in place for many years, and yet emerging markets have pretty consistently underperformed most developed markets since 2011. A combination of falling commodity prices, heightened political risk, slower (but still relatively brisk) economic growth, rampant corruption, a stalled reform agenda and limited earnings growth have all weighed on performance to one degree or another across the emerging world over this time period. So while emerging markets appear inexpensive, they are not unambiguously cheap. For Canadian investors, it’s even less clear if emerging markets will prove to be a winning destination for investment capital. As I’ll show, the loonie has tended to move with EM currencies, correlations between EM and Canadian equities have been high, and the sector composition was reasonably similar for a long time. That said, some of these factors are changing and even boosting the allure of holding EM equities in a portfolio. Currency Since the January lows, emerging market stocks have posted sizeable returns in US dollars, but the results are much less impressive in Canadian dollar terms, thanks to strength in the loonie. Some of the same factors lifting emerging market stocks, bonds and currencies also support the Canadian dollar and Canadian stocks: a rebound in commodity prices, a more patient Federal Reserve and less dire news about the global economy, especially out of China. This result shouldn’t seem all that surprising; the Canadian dollar has closely tracked emerging market currencies since 2010 (see the chart below). Consequently, Canadian investors don’t get as much of a boost to performance from appreciating EM currencies when risk appetites are growing and the global economy is accelerating, because the Canadian dollar is typically rising too. That said, EM currencies could potentially appreciate against the loonie given how far they’ve fallen. Click to enlarge Correlation Assets that exhibit a high positive correlation have more muted diversification benefits. If emerging market currencies and the Canadian dollar tend to appreciate together, then what about the correlation between EM and Canadian stocks? Here again, there’s another tight fit and another reason for Canadians to be apprehensive about the diversification benefits of owning emerging market equities. Looking at the chart below, Canadian equities have been much more positively correlated to EM equities since 2005 than to US or other international developed stock markets (represented by MSCI EAFE). That said, we should note that the high positive correlation of EM and Canadian equities have declined in recent years, boosting the diversification benefit. Click to enlarge Composition One reason correlations were this high – and the diversification benefits for Canadian investors this low – may have something to do with the similarity of industry exposures: the energy, materials and financials sectors made up more than half of the market cap of both Canadian and emerging market stocks. In the past five years, however, something interesting has happened. Thanks to the initial public offerings of many high-tech companies, the information technology sector has grown to more than a fifth of the emerging market equity index (see the chart below), whereas it’s less than 3% of the MSCI Canada index. As a result, EM may begin to deviate more from Canadian equities because of shifting sector exposures. The expansion of the tech sector is both a sign of, and offers investors exposure to, the convergence of emerging markets to developed economies. Click to enlarge Although not without risks, we’re warming up to emerging market equities and continue to believe in the possibility of improved investment returns based on better demography, faster growth and pent-up consumer demand. For Canadian investors, we see room for EM currency appreciation versus the loonie and better portfolio diversification benefits over time than has historically been the case. Source: BlackRock Investment Institute and Bloomberg. This post originally appeared on the BlackRock Blog.