You'd Be Stupid Not to Evaluate Risk

"Before the 2008 financial crisis, one of my neighbors took out a home-equity loan from Wachovia, paying around 5%. Wachovia never sent an appraiser to the house, but that isn't the weirdest part of the story. My neighbor asked his financial adviser what to do with the money left after he'd paid some expenses. The adviser suggested a money manager who guaranteed 12% returns, explaining "you're borrowing at 5% and getting paid 12% -- you'd be stupid not to do this."

It was stupid, all right. The money manager was buying homes and hockey teams, and his Ponzi scheme soon collapsed. No warning label said: "The more enticing the interest rate, the higher the risk." Risk is often nebulous, hazy, unmeasurable -- so it is usually ignored. Years of zero interest rates have caused havoc, but with the Federal Reserve raising short-term rates, investors should be extra careful shuffling money around.

Bernie Madoff promised an 11% average annual return and faked brokerage statements before he made off with investors' money. You can almost hear the cocktail-party conversations in New York and Palm Beach: "You'd be stupid not to do this."

Same for the crypto scheme known as Anchor Protocol, which offered 19.5% yields -- practically screaming risk -- with tokens backed by nothing but hot air. It soon imploded. So did crypto hedge fund Three Arrows Capital whose founder told the Journal, "The Terra-Luna situation caught us very much off guard." The word lunatic is too kind.

Recently, bankrupt crypto lender Celsius was offering interest of up to 18.6% annually to attract deposits. Celsius' assets reached $25 billion last October. You would have been stupid not to invest -- except, well, the company now has $4.3 billion in assets and $5.5 billion in liabilities, mostly owed to depositors.

It reminds me of July 2007, when Citigroup CEO Chuck Prince told the Financial Times, "As long as the music is playing, you've got to get up and dance. We're still dancing." His job was to assess risk, and he didn't do it. Citigroup should have sat out the next 18 months.

When you buy high-yield debt, junk bonds with ratings of BB+ and lower, there is a default risk, though it's rarely noted. The best junk bonds today pay 6%. In January it was 4%. In November 2008, as Lehman Brothers and others were imploding, it was 16%. Higher yields imply higher risk. A recession (yes, we're in one) accelerates defaults.

Risk is also built into stock dividends, which might be cut. A famous example: In September 2017 General Electric declared a quarterly dividend of 24 cents for a 4% yield with its stock around $190. Three months later, as the stock slid to $135, GE cut the quarterly dividend to 12 cents for a still-respectable 2.8% yield. By late October 2018, with the stock around $70, GE cut the dividend to a penny. That 4% yield in 2017 was enticing but dangerous. Dividends are a false signal. Ignore them.

Stock prices are based on a company's profits, growth rate and risk. What risk? No one knows for sure. Risks might come from competition, obsolescence, CEO turnover, inflation, Fed rate increases, recessions, wars, pandemics. But the risk can be implied. Investors often look at a stock's price-earnings multiple to judge its value. The S&P 500 today sells at 20 times earnings. That PE multiple was 33 in the 1999 dot-com boom and as low as 7 in 1980.

Stocks with a high PE multiple have an interest-rate risk embedded. How? Lower interest rates mean investors are willing to pay more for a company's future earnings, meaning a high multiple. A company growing at 10% may have a PE of 16, but one growing at 25% could have a PE of 60 or more. Then there are companies that are losing money, and investors pay a high PE on the "potential" for future earnings, as they did with Rivian and Carvana. But when interest rates rise, PE multiples collapse and investors flee, which explains the recent rout of high-multiple tech stocks.

Fed surveys say the inflation expectation over the next three years is 3.6%, and over five years it is 2.8%. That means short-term rates need to be around 4% to 5% to maintain a normally growing global economy. That might be the new baseline for short-term rates soon.

There is a lesson in all this. Do your homework, even if you are buying an S&P 500 index fund. Study the fundamentals, assess future risk, and never fall for the siren call of high yields, especially "guaranteed" returns you'd be stupid not to take." [1]

1. Inside View: You'd Be Stupid Not to Evaluate Risk
Kessler, Andy. 
Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 01 Aug 2022: A.15.