Risk On / Risk Off / Redux
Love it or hate it, “Risk On / Risk Off” has been one of the most popular catchphrases of the last year. Like any catchphrase, it annoys plenty of people, it isn’t always used in proper context, and it’s subject to erroneous and unjustifiable interpretation.
Let’s start with what it actually means.
Risk On / Risk Off – Definition
It’s a very simple term at its core. All “risk on / risk off” means is that some days, investors in aggregate feel optimistic about the global economy and want to take risk. Some days they don’t. Investors have always been that way, but the interesting thing about today’s environment is that when they’re feeling groovy, investors all tend to buy the same stuff. When they get spooked, they all hide in the same places.
“Risk on / risk off” is simply shorthand for describing which kind of day it is in the market.
It didn’t really get popular until last summer, but the origin of the phrase actually goes back a little further. It goes back to the dark days of the financial crisis where investors sold pretty much everything that had risk and bought pretty much anything that didn’t have risk. Everything correlated.
I had a front row seat in the hedge fund industry. I saw hundreds of traders who purported to be “absolute return” managers and claimed zero correlation with the stock market fall right alongside every other risk-asset. Some learned their lesson about what correlation truly means, but even today I see that not everybody in the industry understands. Not every hedge fund trader has given up the ghost of leveraged beta.
As long as there have been markets there have been risky assets and less-risky assets. When investors are worried, they have always pulled the plug and gone to cash or other risk-free equivalents. So in a basic sense, the idea of “risk on / risk off” is as old as the capital markets themselves.
The reason why it became popular last summer is investors are getting spooked with increased frequency. This is merely a function of our proximity to the last crisis. We are all hypersensitive to bits of bad news. Our brains seem to think investing is game of musical chairs where our only risk management strategy is timing. We have to be invested until the music stops and then we try to grab a seat as quickly as we can. So we listen really, really carefully to the music. Our fear is that it could stop at any moment.
Sophisticated investors roll their eyes at this and understand that strategy is garbage. Our brains are broken when it comes to investing, and the idea that timing is our only option for managing risk couldn’t be any further from the truth. There are plenty of solid risk-management strategies that take timing completely out of the equation. The biggest, of course, is true diversifcation. Without spoiling the punchline, that’s where today’s newsletter will wind up.
So read on — today we probably won’t satisfy the “entertaining” component of our threefold-objective, but I feel pretty good that this discussion will be both informative and ultimately useful.
Interesting new tools
I’m fascinated by Dennis Gartman’s new exchange-traded notes, ONN and OFF. They are based on the Fisher-Gartman Risk index, a rather interesting endeavor to identify and weight “risk assets” against “conservative/non-risk assets.” In principle that sounds rather easy — after all, the stock market is obviously a risk asset and Treasuries are obviously a non-risk asset. But what about Corn? Or the Swiss Franc? How do you weight them?
There’s certainly a degree of arbitrariness with this. Gartman’s risk index would probably look a little different than yours or mine. But keep in mind that this is one of those questions in investing that doesn’t have a correct answer. And that’s OK. My risk index is close enough to Gartman’s which would be close enough to yours. Close does count in investing; striving for perfection is a great way to fail.
Let’s start by looking at the Risk On ETN (ONN):
Long
20% – Crude Oil (WTI)
14% – Brent Crude
14% – Euro Currency
10% – Corn
9.2% – S&P 500
8% – Australian Dollar
6% – Heating Oil
6% – Copper
6% – Canadian Dollar
5.5% – Hong Kong Index
5.5% – NASDAQ QQQ’s
4% – Gasoline
4% – Gas Oil
4% – Wheat
4% – Soybeans
Short
-16% – 10yr US Treasuries
-12% – Japanese Yen
-12% – German Bund
-6% – 10yr Gilt
-4% – Swiss Franc
In aggregate, ONN is 150% long and 50% short. It’s split roughly into thirds. 1/3 Energy, 1/3 Equities, and 1/3 Currencies, agriculture, and metals. That strikes me as a very effective weighting. The commodities markets are too frequently given short shrift to stocks & bonds. Commodities tell us a lot.
The Risk Off ETN (OFF) is simply the opposite. It’s long the risk-off stuff like Treasuries and the Yen and short all the risk-on stuff. In equal proportion, too.
Decomposing Risk
In that portfolio mix, the first thing that jumps out — to me, anyway — is the long Euro / short Yen positioning. Longtime readers are probably grinning right now because we started talking about that years ago! For the uninitiated, the idea is that investors can get a fairly accurate reading of the planet’s collective risk appetite just by looking at a simple Euro/Yen cross.
Some of you will recognize this chart:
This is another one of my favorite charts of all time. I can’t think of anything that better describes the feel of the last decade. (Anybody notice that this thing has displayed ugly technicals since 2008?)
Anyway, I think it’s really cool that they built that Euro/Yen cross into these new Risk On and Risk Off ETNs.
The other interesting bit is how heavy a component energy represents. 48% of the 150% long side is energy. That may seem like a lot, but energy is another one of those assets that has always acted as a proxy for risk appetite. When investors are feeling optimistic and bullish about the global economy, they bid up the price of energy commodities. A growing global economy, after all, is one that happily consumes more and more energy at higher and higher prices.
Also: where is Gold?
Astute readers may have noticed that Gold is nowhere to be found in this index, despite the financial media’s consistent and wrongheaded insistence that gold is somehow a “safe haven,” risk-off type of asset. Gartman is no dummy, and he understands that gold represents neither a risk on nor a risk off asset. Gold is its own animal. It does it’s own thing. Anybody who’s ever read anything I’ve ever written about gold — and I’ve written plenty — should understand the stark independence of our friend, the yellow metal.
The final thing is that each one of these things represents a pretty darn cool portfolio on its own. I love the way that it goes long certain assets and short others. I am a HUGE believer in long/short strategies. The three of you who read my book, The Trade of the Decade (shamless plug!), know that the actual trade of the decade is constructed with a big long/short framework.
As an investor, I’m a lot less comfortable predicting whether an asset will go up or down than I am at predicting whether one asset will rise or fall relative to another asset. That’s just how I naturally see the world, and the other thing you longtime readers all know is that if you aren’t investing in a style that naturally suits your personality, it’s time to get with the program. Don’t try and be like Jim Cramer, or George Soros, or even me, for that matter.
Tracking Performance
Historically, investors have always turned to the VIX to gauge risk aversion or fear in the marketplace. I like looking at the VIX too, but I understand its limitations.
So let’s see how these risk on / risk off securities have done this year. Here’s Risk On (ONN):
That probably won’t surprise you. Investors were extremely bullish to begin the year but then got quite bearish because of Europe and a slowing U.S. economy.
What’s interesting is what happens when you overlay the S&P 500 with ONN:
As ONN was peaking and flattening out, the S&P kept going up.
Now, the SPY is a significant component of ONN, so there should be some correlation between the two. But when they start trending in different directions or one is outpacing the other, it’s worth further inquiry.
This is basically just another way of saying “look to other places to confirm the move.” Dow Theorists always look for the trend in the Transports to confirm movement in the primary trend. Energy analysts look up and down the spectrum to confirm trends in crude oil. And when determining whether a risk on environment will continue, you have to look in multiple locations.
The stock market had a pretty good month in March, but by the end of it, you would have noticed that other risk assets didn’t follow along. Perhaps that would have motivated you to take some money off the table, perhaps not. A decision like that would depend on your basic macro thesis. If you’re fundamentally cautious like me, it probably would have caused concern. If you were fundamentally optimistic, probably not. It’s tough to sell short a chart moving strongly in one direction. Turning points are impossible to predict.
Along the line of turning points, you can see that ONN does appear to be putting in a bottom right now and beginning to trend higher.
Near the end of May I wrote an article about a really cool contrarian sentiment indicator that was flashing a 6-month buy signal. For a trade of that length, the timing appears pretty darn good — lucky, to be honest. It looked like I was wrong about that trade for a couple of weeks, but the trough now seems a little more clear. I was uncharacteristically optimistic near the end of May and uncharacteristically confident about the strength of that signal. I only really feel that way when the market is at relative extremes. I believe very passionately in the phenomenon of mean reversion.
So we’ll see where the market goes in the next 6 months. There’s plenty of time for me to be wrong, but I still think that the market wants to move higher, and eventually will as long as Europe keeps applying band aids where necessary. I am ridiculously bearish on the EU for the next decade, especially relative to the U.S. — remember, I like to evaluate one asset against another. But I have always believed and still believe that Europe will avoid a massive, acute banking crisis.
Don’t get me wrong, their economy is in for a long, ugly haul as they sort out the fundamental brokenness of trying to run a currency union without a corresponding fiscal or political union. I just really, really, really think it’s going to happen without any major systemic meltdowns. Not like 2008. The next systemic crisis will be one that relatively few people see coming. And there are waaay too many people out there right now worried an acute EU banking crisis.
That’s why OFF has so dramatically outperformed ONN in the last few months.
Careful, caveats
Let’s go back a little bit further and see what happens when we chart ONN against OFF. Since they are perfect opposites of one another, we would expect perfectly opposite performance. In other words, if we owned equal amounts of both, we might expect to break even every day.
As you can see, that isn’t exactly the case.
ONN is down -7% in the last six months while OFF is up only about 3%. That skew exists because of fees, transaction costs, rolling, rebalancing, the general nature of how performance is calculated, and other factors endemic in exchange traded notes/funds. These things aren’t perfectly efficient devices. But these two don’t seem that bad at tracking their objectives. Nowhere near as bad as commodity ETFs like UNG or USO.
And they are fascinating little devices to watch. They contain massive amounts of information. I wasn’t aware of these until I heard Dennis Gartman mention them in an interview. I’m impressed. There are tons of ETFs out there whose existence, in my opinion, is indefensible. Many are shameless mechanisms for the investment houses to pocket fees or to give adrenaline junky day traders more ways to get their fix. ”Hit me up with 3x short the financials!”
But I feel like ONN and OFF are securities that actually add value. I can see them being extremely useful for basic hedging purposes. And they tell us something interesting and useful about the marketplace.
Here’s a chart of how the index that these are based on (^FGRISK) has fared since 2006:
I think that’s a neat chart for no other reason than it underscores the global froth of the pre-crash days and how far we still have to go to get back to that, despite the fact that the S&P is getting close to its old highs.
I listened to an interview with Mr. Gartman a while back and he talked about how they derived the index. They didn’t just pick and weight these assets willy nilly. They did a lot of research on correlation and market movement to try and derive the right assets with the right weighting to measure generic investor appetite for risk. And I have no doubt that these weightings will change over time. But the goal will always be the same: to measure, as effectively as possible, the global appetite for risk in the current environment. An index like this has no choice but to be dynamic in its methods over time.
To be clear: I’m certainly not advocating that you buy ONN or OFF. I don’t own them, and neither does my firm.
Exchange traded notes make me a little nervous about how they are technically constructed. I haven’t read through the entire prospectus for these, and that’s something that every investor needs to do before buying an ETN. Without getting too wonkish, ETNs are actually debt-securities, which means you’re dealing with a slightly different set of counterparty risks than stocks. If UBS declares bankruptcy, there’s a chance these ETNs, as debt securities, go down with it. (geek’s note: and they’re actually callable after December of this year, which may or may not be standard practice for ETNs.)
Anyway, talk to your financial advisor before doing anything crazy.
Never take investment advice from some faceless guy on the internet.
Why Risk On / Risk Off Matters
To manage risk, you need to understand risk on / risk off. As I said, you don’t do it by trying to time the market, being in on the risk on days and out on the risk off days. Nobody can predict that. You use risk on / risk off to understand the assets at the core and how they move relative to each other. The nature of that movement is crucial.
The single most powerful concept in all investing is diversification. It’s an idea as old as time. Yet it’s frustratingly misunderstood by amateur investors.
Do you think you’re getting diversification by owning emerging market or euro-denominated stocks alongside your U.S. names? Think again. Even owning commodities outright won’t really help you diversify.
Because I hang out in the alternative space, I get a little spoiled. I have access to a large number of trading strategies that not only have exhibited zero correlation with the stock market and other risky assets, but they have no fundamental reason for correlating with risky assets. These strategies don’t correlate with risk assets because sometimes they’re long risk assets and sometimes they’re short. Usually at the same time. The bad news is that it takes a lot of skill to have a strategy that 1. makes money and 2. doesn’t correlate with anything else. Believe me, many try and a disturbing percentage fail. It’s not a space for everybody, nor is it appropriate for every investor.
The good news is that when it comes to diversification, that long/short framework can be ridiculously powerful. When you get long one risky asset against another risky asset, it can take all or most of the “risk on / risk offiness” out of the trade. When the market is doing its thing and moving altogether in one direction, in all likelihood one of your risky assets will be going up while you’re losing money on the one you’re short. That eliminates a lot of volatility and isolates long-term performance to the degree to which the one outperforms the other.
I know that this is kind of a technical idea, but I’m serious: if you can grok this concept of long/short investing, you will separate yourself from 99% of all other investors. Those of us in the business take it for granted, but it’s an idea that is largely absent in the mainstream.
