Goldilocks, Don't Get Too Comfy While Sleeping in a Bear's Bed!

Everything is just right in today’s markets. Corporate earnings are robust and looking to continue their strength, monetary accommodation from central banks is plentiful, inflation is moderating, unemployment is at pre-crisis levels, and U.S. and world GDP in aggregate is growing nicely: not too hot, not too cold – just right!

Most all financial markets are up this year in a rare show of solidarity – stocks, bonds, gold and real estate. Well, maybe real estate is a little too hot in the Seattle market (our home town), but you get the point.

We all feel very comfortable with rising asset prices and risk seems to have taken a snooze. As an example of how good the markets feel, the Financial Times recently reported it has become possible to put on a fairly simple options protection trade that would deliver a 25 times return on the premium paid if the S&P 500 index were to fall by 7 percent in the next month.

If protection is so cheap, it is becoming increasing obvious to us that we should be buying more!

As we look in the markets every day at investments for portfolios, we are drawn to this cheap protection. No, we are not buying put options on the S&P, but in the bond world if we can by an “A” credit vs a “BBB” credit and only give up 10 bps of credit spread, or buy a shorter bond versus a longer bond and only give up a small amount in yield, we will buy this cheap protection. There will be plenty of time to buy cheap risk when the bears stumble through the front door – which is not a matter of if, just when. The current situation is really no different than past periods of market calm.

In the fairy tale, Goldilocks gets off easy when she is discovered. She just jumps through a window and runs away to avoid the bears. In real life it can end badly if you are awoken by a hungry bear. Consequently, we will buy cheap protection when offered, and as the markets continue to grind higher we will keep one eye open and one foot on the ground.

Source: The Wall Street Journal, The Financial Times, Bloomberg