What Does Risk Mean in Today’s Market?

What Does Risk Mean in Today's Market?

October showed a glimmer of hope in the form of a rally that then faded in November, with the sovereign debt crisis in Europe overshadowing a strong third-quarter earnings season and improving domestic economic data. Unsurprisingly, Europe is falling into a recession that is starting to depress global economic activity. Financial markets remain at the mercy of high volatility as fear of further fallout to the global economy and markets remains center stage. The Russell 2000 declined precipitously during much of November only to rebound in its last several days. As this year comes to a close, investors will most likely look back at 2011 and remember its striking macro headlines and continued high correlation. We, however, will remember 2011 for the valuation opportunities that were created and investors' pronounced lack of appetite for risk.

From our perspective, the small-cap environment is fraught with opportunities. Today's attractive absolute valuations are an opening to find bargains that will drive results for the next three to five years. It is easy to forget in the daily barrage of dismal macro news, extreme volatility, and high correlation that in these uncertain times, active managers have the ability to find real assets with solid balance sheets and attractive absolute valuations.

It's important to remember that the fundamentals of the underlying businesses do not fluctuate as dramatically as the daily swings in the prices of their stocks. As we have always done during difficult periods, we are adding risk by actively buying what we regard as attractively undervalued companies as the market is removing it by reducing valuations. So while many investors continue to focus on daily volatility, seizing on every piece of macroeconomic or political news to gain a sense of the overall shape of the economic future—and position their portfolio accordingly—we remain focused on individual companies
and the opportunity each presents.

Although equities are pricing in a great deal of risk, investors are responding by exiting the asset class. In a recent report from Cirrus Research, Satya Pradhuman indicates that even after October's powerful rally—the third best month ever for the Russell 2000 Index—investor's risk appetite again disappeared (see chart below). He goes on to state that "sentiment readings such as the Cirrus Risk Score (CRX)* tend to act as market contra signals. The expected return on equities jumps higher one year after the CRX breaks the lower band, on average yielding gains in excess of 20% in those 12 months."

Investors are clearly positioned for and are expecting the worst, which is helping to exacerbate valuations. It's true that the challenging backdrop is unlikely to ease as we head into 2012 and contagion risk remains. Yet any stability could be powerful and usher in a more normalized environment, one marked by positive long-term returns for equities with normal corrections. This would be close to an ideal environment for active managers with an absolute return orientation such as ourselves.

Stay tuned… Happy Holidays!
FDG

*Cirrus Risk Score (CRX):
The US Cirrus Risk Score (CRX-US) is a cross-market measure of investor willingness to assume risk. A high score indicates market sentiment is speculative while a low score indicates defensiveness. CRX Components: Market Capitalization, Beta, +/- Net Income, +/0 Dividends, Earnings Stability, LIBOR vs. Treasury Spread and Emerging Markets Return vs. S&P 500. Designed to gauge overall risk tolerance of the market, the CRX is also a contra-indicator for identifying market-timing opportunities in risky assets when risk aversion is high.