Sleep With One Eye Open

"Hush little baby don't say a word
And never mind that noise you heard
It's just the beasts under your bed
In your closet, in your head"

"Enter Sandman" by Metallica

Enter Sandman - Metallica

Risk is with us every day, from the moment we awaken, to the moment we fall asleep, and then in our dreams. Risk never sleeps. Of course there is more than one kind of risk, and in this letter we generally focus on financial risks. 

"Risk," as John Adams wrote in his 1995 book titled "Risk," "is defined, by most of those who seek to measure it, as the product of the probability and utility of some future event. The future is uncertain and inescapably subjective; it does not exist except in the minds of people attempting to anticipate it. Our anticipations are formed by projecting past experience into the future. Our behavior is guided by our anticipations." 

The risk monster currently hiding under the bed of finance is the threatened collapse of the Euro, a paper currency of no intrinsic value. The really scary monster hiding in the closet, is what the Euro's potential collapse means for other paper currencies with no intrinsic value, i.e., the US dollar. Are these currencies monster-proof?

One of this summers much anticipated Hollywood remakes is Karate Kid. You remember the Karate Kid, don't you? That famous scene where Mr. Miyagi teaches the young apprentice "Daniel Son" how to wax a car, "Wax On," "Wax Off."  The markets have been playing a similar remake of late called, "Risk on," "Risk off." This movie involves investors rushing quickly to either put on risk or take risk off (aka de-risking). 

Many investors (myself included) use diversification to help manage and lower risk, but so far this year diversification has hurt returns. Any diversification outside of US Treasuries and US stocks, say to; International bonds, International stocks, International REITs, or Commodities, has led to under-performance. Right now the US markets, especially Treasury bonds, are perceived as the safe place to hide, the monsters are mostly overseas.

The funny thing about this game is that Mr. Market has a peculiar way of switching the labels of what is perceived to be the "safe" investment with the "risky" investment when we least expect it.

Remember, it was only a year ago that the Euro was the safe haven currency of choice for investors. The recent collapse in the Euro is correctly blamed on the debt crisis in the PIIGS nations. However, the debt problems in the Eurozone were well known for years. The only thing that changed was perception.

Perception is the only thing propping up the US dollar. Europeans thought they could work their way through their debt problems unscathed until, well, they couldn't. Americans have a similar affliction of head-in-the-sand disease that ignores large-scale funding problems. For now the focus is on Europe, the dollar will continue to profit from safe haven capital flows until, well, it doesn't.

Swings in the dollar, and by extension inflation, will be sudden and dramatic, mirroring the confidence of investors.

 

Now of course I don't know what the future holds, all I can hope to try and understand is our present situation, and presently my models have us getting more and more defensive. This week we went to neutral (from bullish) on US equities, and to neutral (again from bullish) on emerging market bonds. Our current allocation to cash equivalents is now at 31.5%. 

"Somethings wrong, shut the light
heavy thoughts tonight
And they aren't of snow white
dreams of war, dreams of liars
dreams of dragon's fire
and of things that will bite
sleep with one eye open
gripping your pillow tight" 

Be careful out there,

Chris Wiles

www.rockhavencapital.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.