Higher prices means more dangerous times

If the market perceives less risk, prices rise.

This is counter-intuitive, but an example should illustrate.

If risk-free rates are 1% and something is trading at a guaranteed yield at 2%, that something will trade at double the price of the risk-free product (all other variables being equal).

If that guarantee is less than 100%, then risk will cause the price of that instrument to decline.

Thus, it can be assumed that higher prices means that the market is pricing in less risk that a specific investment will fail to achieve their projected return on equity (or debt, whatever the case is).

The S&P 500 is up 6.4% year-to-date, despite all expectations. I’m willing to wager that most fund managers are underperforming this index and are starting to feel political pressure for their underperformance (“you’re in bonds???”). The way that psychology tells you to compensate for underperformance is to increase risk (i.e. equities) and join the party because it is the only way to “break even”.

The mentality shift that we are starting to see is startling – no longer is holding cash and being cautious is part of the game, rather, we are starting to see a more aggressive leaning towards risk-taking. Valuations? Who cares about valuation when you’re being left behind like a renter in the Toronto real estate market!

While I am not suggesting that you go out and purchase shares of Snap (Nasdaq: SNAP), be cautioned that I believe we are going to be entering a mania phase that will be punctuated with volatility that will be higher than what we have seen over the past year. Volatility means both up and down.

The federal reserve will try to dampen this process, but they will probably be too slow to react.

To outperform in the markets, despite what literature says about timing, market timing is everything. You want to be in cash when the markets are cratering, and you want to be fully invested when the markets are rising. While it sounds easy, it most certainly is not.

During periods of heightened volatility, an investor pays dearly for liquidity. Stocks and bonds that trade at reasonable valuations and seem like a “lock” suddenly are sold and taken out in the back and shot like cattle with mad cow disease. When the markets are like this, it is the time to be deploying cash instead of trying to shift things around in the portfolio to raise it.

The core reason for my outsized performance gains is not necessarily by doing well (yes, this helps), but rather being able to side-step market crashes when they occur. Sometimes my alarm clocks strikes and there is no need to wake up (I was ridiculously cash-heavy in 2014 and 2015), but better safe than sorry.

This is not a prediction for a market crash, but rather that I’m paying extra judicious caution when it comes to the portfolio. When you have Drudge and Trump bragging about the gains the stock market has seen since his election, coupled with friends asking you about investing, it makes me extra paranoid.

4 thoughts on “Higher prices means more dangerous times”

  1. “If risk-free rates are 1% and something is trading at a guaranteed yield at 2%, that something will trade at double the price of the risk-free product (all other variables being equal).”

    I think you mean half the price, not double? If A and B both pay $ 1, and A trades at 1% yield and B at 2%, A will be at $ 100 and B at $ 50.

    An increase in risk will cause the price of B to fall further.

  2. @Thijs: Let’s pretend the prevailing risk-free interest rate is 1%.

    So if you invest $100, you get $1/year.

    So I present you something that gives you a risk-free $2/year.

    All things being equal you will pay $200 for this instrument.

    My wording in the paragraph above probably wasn’t the best way to word things, but your thoughts are appreciated!

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