Predictions: Win Some, Lose Some.

So what if it’s not January.

The last posting, “Investing PART 15,” mentioned that volatility this year would be different from last year. The difference affects the return on the investment strategy discussed in that posting. The logic: One of the factors determining option prices is volatility. So far this year, volatility has been more like the second half of 2010 than 2011. Thus, it seems the prediction that volatility this year wouldn’t resemble 2011 has been borne out, and it has affected the return on the strategy. Nevertheless, the nickels are still there to be picked up.

My second fearless forecast looks more questionable. Logic would suggest that sometime this year financial economists should recognize that the concept of (and purported measure of) the risk-free rate of return is a joke. It seems logical since both the President and congressional leaders (of both parties) openly discussed defaulting on Treasuries. (Treasuries are the traditional definition of the risk-free rate of return). So, default risk is there. (If you think not, look at how the voluntary Greek rescheduling was structured. One has to be increditably naïve to think that the US government wouldn’t resort to the same sort of picking winners and losers. Just make it politically advantageous and it will happen).

Bernanke and other Fed official regularly debate when rates will rise. That will affect the price of existing bonds. So, interest rate risk is apparent. To argue there is no downgrade-risk is counter factual. The currency risk was highlighted earlier last year when we saw an international flap over the currency impact of Fed policy. In the April 1, 2010 posting on this blog, “Beware the risk-free return,” other risks were discussed.

Yet, financial economists persist in misinterpreting risk in order to defend the theoretical edifice they’ve built. This blog has often pointed out how that theoretical structure yields some very useful ideas that can be employed to increase return and reduce risk. However, keep in mind that the mathematics of the structure are often employed to fabricate a quantitative precision that just doesn’t exist in the real world of investing. More importantly than false precision, the edifice is misleading investors regarding risk.

To illustrate, the ECONOMIST (3/17-23/2012) had an article on the spread (i.e., difference in returns) between stocks and Treasuries (“Shares and shibboleths: How much should people get paid for investing in the stock-market?”). The spread is known as the equity risk premium. The article first discusses before the fact verses after the fact risk assessment. That investors are sometimes wrong isn’t a very enlightening explanation of the spread. Then the article provides the following very traditional definition:

“Another explanation for the high returns is a paradoxical one: that equities have become less risky.”
“The first step is to define the equity risk premium more exactly….break it down into the following components: the dividend yield, plus the real dividend growth rate, plus or minus any change in the price/dividend ratio (the inverse of the dividend yield), minus the real risk-free interest rate.”

This is all well and good EXCEPT that the conclusion that equity risk is the total explanation is wrong mathematically and factually.

Mathematically the spread is the difference. It is wrong to attribute a difference to the value of only one of the two numbers that generate the differences. The math is wrong if one focuses just on the risk in equities. One can’t solve a - b = c and d - e = f and c > f for a, b, d, or e. The equations say nothing about the relationship between a and d. Just assuming that b = e is a copout. The result is simply a restatement of the assumption.

Factually, 1) Treasuries have been downgraded from their almost default risk-free status. But, even when Treasuries where triple A, there was always some default risk. 2) Short maturities reduce but do not eliminate interest rate risk. 3) Especially since, as implied in the WALL STREET JOURNAL (3/26/2012) article entitled “Treasuries Pile Up With Dealers,” the assumption of perfect liquidity is violated. When dealers have to accumulate Treasuries beyond levels they require in order to maintain a liquid market, they are creating the illusion of liquidity by suppressing price discovery. The violation of the assumption of market liquidity should be the nail in the coffin of risk-free return nonsense. Risk-free without market liquidity that supports price discovery is a contradiction. As Spock would say, “that is illogical.”

In short, Treasuries have risk and a change in the level of that risk is an equally logical explanation for changes in the equity risk premium. Investors would be well served if financial economists would sacrifice their quantitative precision and actually address risk.