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Risk On, Risk Off

There was a time when investors could diversify their risk by owning several different asset classes, like stocks, bonds and commodities. They could rest assured that if one asset class went down, other asset classes would go up to compensate.

This strategy worked well for decades. But over the past few years, things have changed, and I think they've changed for good.

So, who's to blame for this shift? Central banks. They've printed mountains of cash, which are now sitting with large institutional investors like pension funds, sovereign funds, banks and extremely high-net-worth individuals.

When these large investors feel that conditions are favorable, they flood into the markets one after the other, creating a tsunami of cash. But they don't just move into one asset class — they have far too much money for a single class or geographical market to absorb it all.

Instead, they rush into all asset classes, causing them to rise in unison. This creates what is now called a "risk-on" market environment.

Conversely, when market conditions are adverse — due to poor economic data, geopolitical tensions or structural issues — large investors pull their cash out. But again, they don't just pull out of one market or asset class; they pull out of all of them at once, and flood into U.S. Treasury bonds, which are still the safe haven of choice for global investors. This is called a "risk-off" market environment.

Lately, the markets have swung wildly between risk-on and risk-off states. These phases have lasted around six to eight weeks at most, with most of the market movement coming in the first week or two. These are much-shorter, more-volatile trends than we've seen in the past, and it makes things difficult for individual investors.

By the time most people realize we're in a risk-on or risk-off state, the big move is already over, and they end up buying high or selling low.

The key to making money in this type of environment is to avoid following the herd. Instead, try to anticipate when these risk-on and risk-off phases will switch, and position yourself ahead of the curve. Of course, this makes it much harder to call the tops and bottoms of the markets, so most investors will have to settle for capturing a small fraction of the moves.

In addition, it's only going to get more and more difficult for the buy-and-hold investor to prosper, because global central banks are just going to keep printing money.

However, it is still possible to profit whether risk is on or off. The key is to be in the right types of assets. In my own portfolio, I take a long/short approach to reduce the volatility of market swings, and I try to position the portfolio to anticipate changing market sentiments.

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Tuesday, 25 June 2024

Derivative transactions, including futures, are complex and carry a high degree of risk. They are intended for sophisticated investors and are not suitable for everyone. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, and all of which can adversely affect actual trading results. For more information, see the Risk Disclosure Statement for Futures and Options.