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Generational Dynamics Web Log for 6-Mar-07
Pundits are suddenly talking about (gasp!) "risk aversion"

Web Log - March, 2007

Pundits are suddenly talking about (gasp!) "risk aversion"

Fearing full-scale panic in the mortgage loan marketplace, as shares of several mortgage lenders fell 20-30% on Monday.

Fremont General Corp. sent employees home after being informed of a federal criminal probe. As I've recently said, history tells us that we should expect many people to go to jail before all this is over. Morgan Stanley, Goldman Sachs and Merrill Lynch have just had their bond ratings lowered to Baa2 -- almost "junk" status, because these investment firms have major exposures to losses in subprime mortgages.

The subprime mortgage marketplace has, for all practical purposes, been shut down for the time being. The collapse of subprime mortgages may or may not be spilling over into prime mortgages, and there's even some worry about the normally solid commercial mortgage market.

Pundits on television pretty much expressed the opinion is mostly that "there's nothing to worry about," but there was a change on Monday: The appearance of the phrase "risk aversion." This is a phrase I've used on this web site for years, but it's the first time I recall hearing it or reading it among the financial pundits. And I heard it several times on Monday.

It reflects that investors are less willing to take risk than they were even a few days ago. They were really shaken up by last week's stock market turmoil.

I look at this question of risk aversion over a much longer time period.

My mother, who was forced to get find a job for $8.00 per week when her father's candy store went bankrupt during the 1930s was a risk-averse person. She never spent an unnecessary dime, and shunned credit. Most people who lived through the horrors of the Great Depression were extremely risk-averse.

When those risk-averse people were investors and financial managers, our whole economy was run on a sound basis. But when the Baby Boomer generation took over as senior financial managers, risk aversion was thrown about the window. The result was the stock market bubble of the late 1990s, and the following housing, commodity and credit bubbles.

I've been using my own informal method for measuring risk aversion, or lack of it.

At the bottom of the home page of this web site, there's a graph that changes weekly showing the S&P 500 price/earnings index for the last ten years. Here's the chart as of Mar 2:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 2-Mar-2007. <font size=-2>(Source: MarketGauge ® by DataView, LLC)</font>

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 2-Mar-2007. (Source: MarketGauge ® by DataView, LLC)

The top part of this graph shows the S&P 500 Price/Earnings ratio for the last ten years. During this period, investors have been willing to far overpay for stocks.

We can think of the willingness to overpay for stocks as lack of risk aversion. Since 1995, and continuing until the beginning of 1994, P/E ratios were astronomical, indicating that investors were vastly overpaying for stocks. At the beginning of 2004, the unexpected failure of unemployment to fall frightened investors, and they became more risk-averse than the had been.

So, I hope you get the idea: The lower the P/E ratio, the higher the risk aversion of investors.

So risk-aversion has continued at this high level since 2004, going a little higher as the P/E ratio goes down.

Now, if you look at the results of last week, you'll see that the P/E ratio has fallen again, slightly, indicating that investors have become slightly more risk-averse than they were the week before.

This is an informal way of looking at risk-aversion, of course, but it makes a very important point that the pundits are not seeing: The increased risk-aversion began in 2004, not last week.

It's clear that the pundits are confused about this, because many of them expect the market to start reaching new highs again in only a few weeks.

But reaching new highs again requires that investor risk-aversion decrease again. Indeed, with recent earning increases lower than they've been in recent years, it should take a very great deal less risk-aversion for the market to reach new highs.

Now, I've been surprised time and again by the genuine craziness of today's investor, pushing bubbles to newer and newer heights with reckless abandon, and with no appreciation that the higher they are, the harder they'll fall.

Who knows -- maybe I'll be surprised once more, and somehow the stock market bubble will again expand to an even more ridiculous size, and the stock market again will reach yet another new high. But with risk-aversion increasing pretty steadily for three years now, I would not expect risk-aversion to fall again, and I would not expect a new stock market high again.

From the point of view of Generational Dynamics and this web site, it's interesting to see the slow but steady increase of risk-aversion, just as it steadily decreased in the years when the Boomer generation were first taking over. The cycle is progressing and heading for a final climax. (6-Mar-07) Permanent Link
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Generational Dynamics Web Log for 6-Mar-07 Pundits are suddenly talking about (gasp!) "risk aversion"

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Generational Dynamics Web Log for 6-Mar-07
Pundits are suddenly talking about (gasp!) "risk aversion"