Trading Lesson: No Risk, No Reward. Why Tech, Consumer Sectors at Risk

10/09/2018 12:08 pm EST


Landon Whaley

Editor, Gravitational Edge

There is a weekly paper in the small city where I live that covers all the local comings and goings. On the last page of the paper is a section called “The Rant,” writes Landon Whaley Tuesday. Today I’ll rant about risk on and risk off.

Basically, it’s a place for people to unload about everything that pisses them off. People rant about everything from a lack of parking downtown to the person in front of them at Starbucks with their face buried in their phone when it’s time to order.

“You, mid-20’s guy in a blue check shirt in front of me at Starbucks Wednesday morning around 8 am. Stop playing Candy Crush on your iPhone while listening to Nickelback and order your Double Ristretto Venti Half-Soy Nonfat Decaf Organic Chocolate Brownie Iced Vanilla Double-Shot Gingerbread Frappuccino. Some of us actually have to work for a living.”


This week’s rant comes courtesy of all the financial market commentators and gurus who like to say that risk is either “on” or “off.”

Let me be clear, risk doesn’t have an off switch. Risk is always on!

The problem is that most investors have no idea what the word “risk” really means. I’m going to do my best to awaken the risk manager that lies dormant inside you.

Raise your hand if you’ve ever been put to sleep by a finance person spewing terms like beta, standard deviation, kurtosis and skewness. I feel your pain.

A lot of the confusion comes from the fact that the words “risk” and “volatility” are used interchangeably. Let me be clear: risk is not volatility. They are two different beasts.

Standard deviation and other measures of volatility are not measures of risk. These calculations may make you feel warm and cozy, but they can’t help you understand risk, because risk is not a number.

So, what exactly is risk?

Risk is uncertainty about the likelihood of a permanent loss of capital if an unfavorable event occurs.

I’ve left you wanting, haven’t I? You wanted me to tell you the index, calculation or statistical measure that would help you discern just how much risk exists in the world, and more importantly, in your portfolio.

I’m sorry, but I can’t. We can’t boil down risk to a number, but we can assess the probabilities of various outcomes and then position our portfolios in a way that tilts the scales in our favor.

If you are using volatility measures to determine how much risk is in markets or your portfolio, then you’re doing the portfolio equivalent of chewing gum in Singapore.

To give you a better sense of what risk looks like in the real world, outside of an Excel spreadsheet, let’s discuss one type of risk we monitor: relationship status risk.

For starters, this isn’t the kind of relationship risk that occurs when you decide to be honest about how you really feel about your in-laws. I’m talking about the relationships between and across markets. Bill Nye the Science Guy would call this “correlation.”

By a wide margin, U.S. tech and consumer discretionary sectors are the best-performing asset classes in the world, both on a year-to-date and trailing 12-month basis. In fact, there are few asset classes that have performed better over the last 27 months, but the relationship between these two asset classes and the greenback and U.S. yields may be signaling last call at this party.

Currently, both sectors are rocking a historically strong positive correlation to U.S. 10-year yields and a historically strong inverse correlation to the U.S. dollar. For the non-math-geeks out there, this means that as U.S. yields go, so do tech and consumer discretionary stocks. And if the U.S. dollar (USD) zigs, these sectors zag. Obviously, the two-year ramp in yields has been extremely helpful to the outperformance of these sectors.

And yes, the USD has shown strength this year, but the +2.8% rally in 2018 has clawed back only half the decline we saw from January 2017 to February 2018. The 2017 dollar weakness was a huge tailwind for last year’s returns in these sectors as well as the U.S. equity market in general.

These relationships bear monitoring because it’s our call that firstly, the dollar will strengthen from here (primarily based on global monetary policy divergence).

And secondly, 10-year yields are probing their cycle highs in preparation for a multi-year descent (refer to last Saturday’s Weekender Coddiwomple).

If we are correct, then the world’s best-performing asset classes are about to have two tailwinds turn into hurricane-force headwinds.

Even if we turn out to be wrong and a new multi-year cycle of “dollar up, yields down” is not beginning, a regime of this sort that lasts even a month or two could quickly evaporate a lot of the current year-to-date profits.

The other part of relationship status risk to keep in mind is that, like your friends Carrie and Mr. Big in "Sex and the City," the status of relationships between and across markets is constantly changing. Awareness of these shifts can provide you with valuable insight into risks and opportunities that most investors miss.

The Headline Risk Bottom Line
You can’t quantify “relationship status” risk and boil it down to a neat indicator, but the risk is real. Human beings are hardwired to hate uncertainty.

But if you think about it, there is no great reward if you don’t embrace uncertainty. The first time you asked your significant other out on a date, were you certain he or she would say yes? Of course not. There was uncertainty and a possible loss of ego if an unfavorable event occurred and they said “no.”

It’s true in relationships and it’s true in markets: no risk, no reward.

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