Laws Can't Be Broken

"This is one of man's oldest riddles.  How can the independence of human volition be harmonized with the fact that we are integral parts of a universe which is subject to the rigid order of nature's laws." - Max Planck 

Almost everyone breaks the law every day.  Just get into your car and I am sure that pretty much everyone does not come to a complete stop at every stop street or light, neither do you indicate for a full three seconds before changing lanes, not to mention following more than 4 car lengths behind the car in.front of you and don't even get me started on the speed limits!  So imposed laws are often broken but the Laws of Nature can never be.  These laws are set in stone.  The universe follows these laws to the letter, that is just the way it is in nature.

Looking at the the fundamental law of investing that more risk should receive more reward and we find a blend of the human style imposed laws and the laws of nature in that this law is often bent but is never broken.  In times of extreme fear or greed the boundaries of this equation or law are stretched to a breaking point and it is at these times when a reversion to the norm is in order.  The problem with finance is that no-one knows exactly when this reversion will happen we just know that the boundaries are being stretched and the more that they are stretched the more likely it is that the reversion will occur sooner rather than later.

Looking around the world at the markets it is very apparent that the risk to reward investment is skewed toward high risk and low reward or extreme complacency.  Take the stock market as an example, when you buy a stock you are expecting that future company cash flows will provide a base for continued company success and therefore a return on your investment.  The higher the price that you pay the more risk you are taking as the risk premium, or the return, is compressed.  The reason is that if the company growth is linear the returns should be linear therefore paying a higher price today should result in slower future stock appreciation to offset the premium paid.  At present with the stock markets around the world all near or at all time highs with no real improvement in the global economic outlook it is clear that unless the outlook improves significantly that returns on new stock purchases will be far lower than during the past three years and have a high probability of being negative.

Another example is the high yield bond market.  As investors have tried to find yield they have turned to increasingly risky investments.  Yields of bonds in Greece, Portugal, Spain and Italy are at levels not seen since before the Great Recession began while their ability to service these debts has barely improved since 2008.  Money from the housing bubble has flown into these high yield markets for the simple reason that the "carry" (the spread between the interest rate received on the investment less the cost to borrow the money to buy the investment) is so low that the investors are drawn in to invest in these assets believing that the spread will last for the life of the loan.  Furthermore with money as cheap as it is right now investors believe that the problems will alleviate themselves by a magical wave of the wand as somehow more debt at lower interest rates will be the solution!

I could go on but it is clear that until investors realize that the investments that they are making are high risk with low levels of expected return and that the law requires a reversion, the markets will continue to compress the risk premiums.  In such an environment it is not a case of if there will be another financial crisis it is just a matter of when do investors wake up to the lack of return and all run for the exits.  Remember that you may get away with a few misdemeanors for a while but at some stage the law will enforce itself.