From the blog

Risk Drives the Investment Engine

Throughout history risk tolerance trumps all.

Investors and analysts study market internals across individual stocks, industries, sectors, niches and security types, dutifully seeking to understand what we’ve always known:  For all of the vast information, the lessons aren’t new ones.  Long-term investment returns are tied to value while short-term gains in shorter cyclical periods within the markets’ longer cycles, are driven by risk tolerance. 

No surprise that when market internals are favourable, market overvaluation is usually ignored in pursuit of short-term gain.  When internals go south, risk-aversion surges north.

The role of central banks is equally predictable and has little cause and effect on the stock market, but is directly linked to investor willingness to assume – or avoid – risk. Investors speculate with favourable market internals and retreat to safety when they deteriorate. The yield-seeking speculation driving the purchase of stocks, or a host of other assets viewed as risky, happens when a large segment of investors believes that doing so won’t expose them to broad capital losses.

Central Banks quantitative easing can be read both ways. The case can easily be made that too many investors see what they want to see and filter-out what they don’t, especially when internals are favourable – driving speculation as investors reach for yield confident that sharp price declines won’t wipe out their extra gain. 

Valuations, elevated even when market internals may be unfavourable, may be inadequate incentive for investors to forsake safe liquidity and more modest returns. Ultimately, Central Bank easing may not be enough to stimulate speculation when market internals fundamentally deteriorate. 

Typically, what predictably follows unexpected economic weakness is most often decline.  Rate cuts may not be welcome and may be not only ineffective, but a signal that the worst is still to come.  There is nearly of century of historical evidence to support this.

Look back to 1930.  The Fed began cutting rates two and a half years before markets finally found the bottom. Seventy-one years later, in 2001, the Fed cut rates as the two-and-a-half- year bear-market collapse was only beginning. Federal funds rates, first cut in 2007, were cut to the bone through the crisis of the Great Recession.

But here’s the big lesson. Reductions of a fraction of a percent in interest rates can’t be relied upon to drive investors’ willingness to expose themselves to major losses when the market internals to warrant taking on risk simply aren’t there.  As has always been the case, there is no greater driver than investor willingness to accept risk, and no greater brake on growth, than aversion to it.