Global stocks are up over 60% since March lows, and investors are slowly beginning to subscribe to the notion this is really a bull market.
Risk is an essential market component—without it, potential returns would be meager, and there would be little incentive to invest or lend.
As risk appetite continues to increase, the economy and markets will benefit.
Anyone who's gone swimming in ocean waters knows the fear and pain that can come with getting trounced by a big wave—or worse yet, a whole set of big waves. After being tossed around like a rag doll, and held underwater for what seems like an eternity, you emerge, stagger back to the sand, and swear you're not going back in. A brutal bear market, the likes of which we just experienced, can have the same effect on investors. However, the swimmer will likely wade back in again next summer, despite the fearful memories. In the face of a new bull market, stock investors are beginning to do the same.
Last fall's financial panic won't soon be forgotten—liquidity dried up as banks practically ceased lending to each other for fear they might not be repaid. Panicked investors, fearing a financial system meltdown, demonstrated extreme risk aversion and dumped just about anything involving risk (stocks, commodities, corporate bonds, muni bonds, structured debt, etc.). Meanwhile, demand for "risk free" assets like US government bonds surged, causing yields to plummet. A year later, it seems investors are ready to dip their toes back in the water, and risk appetite is on the rise.
Global stocks are up over 60% since March lows, and investors are starting to subscribe (albeit slowly) to the notion this is really a bull market. Despite lingering hesitation, there are signs investors are returning to riskier assets. Long-term mutual funds, which experienced tremendous selling in fall 2008, have now seen net inflows for the past 26 weeks. In 2009 (through August), $226.4 billion flowed into open-end funds (compared to $251 billion in outflows in the second half of 2008). While this cash is predominately funneling into fixed-income funds, the activity still implies investors are choosing increased risk over holding cash.
The S&P 500 is already up nearly 4% in September, and buying has occurred across asset classes—stocks, bonds, and commodities—despite fears seasonal investing trends would doom the month's returns. Last week, the TED spread (a widely followed risk indicator tracking the difference between 3-month borrowing costs for banks and the US Treasury) dropped to 2004 levels, signifying increased confidence in financial firms. Mounting signs confirming impending economic recovery (here and abroad) are likely fostering the return of risk appetite.
Despite the negative connotation the word "risk" carries (especially in the wake of last year's events), it's an essential market component. Excessive risk can be problematic, but so can excessive risk aversion. Without risk, potential returns would be meager, and there would be little incentive to invest or lend. Hypothetically, if investors avoided risk altogether and buried their cash in their backyards, economies would crumble—start-up firms wouldn't find investors, companies wouldn't get loans, consumers would lack access to credit. As risk appetite continues to increase appropriately, the economy and markets will benefit.