Lately, a lot of correlations seem to have broken down, and now yen and gold are trading in tandem like most things not-US-Dollars. Then arguably, one encounters oddities when correlations redraw and hedges and proxies need be removed. To make sense of this, I will wax philosophical and try to rack my brain to figure out what risk assets really are. You probably already know what safe haven assets are: assets that retain their value nearly no matter what the circumstances.
Let me start with how I choose to define risk assets:
An asset or claim that might fluctuate in value subject chiefly to known and appreciable risks that fundamentally and intrinsically are related to that asset.
Lets use a casino as an example of where I distinguish between risk assets and gambles:
If you want to increase your available money, and are deeply infatuated with casinos, there are a few ways you can make your capital grow. The first and most obviously procedurally easy would be to assume risk by sitting down and play, say Baccarat. Your money is invariably an asset no matter whether it’s on or off the table, before or after the deals, and you are clearly assuming risks. The rules of the game are simple, use two or three cards, get as close as possible to have the surd of your card total divided by 10 being 9, cards count for number face value only. Bet on banker or player, if you’re right, you get an instant 100% return, if you’re wrong you’re wiped to 0. Risks are appreciable.
A more patient person might think that there are a lot of people that do this, the world economy is (superficially at least) improving, this casino is in a great place with a lot of people that might be interested in going to casinos with their newly earned money and over time earn the House a whole lot, which would increase the share price. Income levels, both net and disposable, as well as disposable income correlation to luxury consumption are widely available, and it’s fairly easy to roughly enough estimate how much more people will become richer as the economy grows, and thus expected spending at casinos. Our second person buys stock of the casino he believes will do best in the future, given his outlook. He thinks the risks are not necessarily easily appreciable, but he can understand them and somewhat estimate them. He converts his cash into an equity stake which is proportional to the value of the company.
Spot where I’d draw the difference?
Of course, the value of your money intrinsically has nothing to do with the faces of two or three or six playing cards! You’re not investing – or making the value of the assets grow – you’re just allowing ownership of your money and an equivalent amount of someone else’s money to be ruled by a set of arbitrary conditions pertaining to the probabilistic outcome of the combination of truly meaningless symbols on a small subset out of a set of paper pieces! The money itself will be worth the same, it’s just a question of whether you’ll own it or not. By contrast, the stock investor converts his money into a stake in the casino’s cash flows, and those can grow to become more valuable! All the aspects discussed above are therefore relevant – like how many people gamble, how much they play for, how much they eat, etc., and all the follow-up discussions like what factors influence people to gamble more and so on – to the casino’s cash flows.
Welcome to S3 Casino! Imagine instead of baccarat that we play another game. I choose whether to flip two coins with sides marked 1 and 2, or roll a die. If the sum of numbers of whatever game I play is 3 or below, I win 100 dollars. If it is above 3, no money changes hands at the end of the game.
Question: How much should I pay you at the start of the game to play with you?
Why, of course 75 dollars. Prior to the start of the game, I have the incentive, no matter how much or little I pay, to flip coins. Unless I make the game fair, you wouldn’t play when I have an advantage, and the die rolling exercise is meaningless.
Now imagine the same rules, except for one detail: you’re the one paying upfront. I still make the call of coins or die, I still win the payout. If you win 15 times in a row, you’ll get 10% profit on whatever you have paid in total upfront and the payouts are redistributed. 90% to you, 10% to me. Lets play, uh?
If you’re still wondering, I just described the (peripheral only?) eurozone investment proposal. It’s a gamble, and if things look to turn up, well you’re likely to find better opportunities elsewhere (Asia? US?), your chances of coming out unscathed are pretty low (unless you’re Jon Corzine and can put the downside on someone else!) and the rules change at the whim of eurozone governments. If Merkel doesn’t get enough payouts, she will then subsequently relinquish you of the right to decide how much to play for, and decide that herself. The Greek mess is getting worse and worse by the day, there are several other eurozone governments in the firing line, banks are still illiquid to the extent they’re not insolvent, and there are simply all the chances in the world for you to lose your money should banks or sovereigns get stressed. Meanwhile, the currency is going down against the real assets you don’t own by the second.
Euro or investments based in that currency are simply a receipt of a different kind of casino at the time being. The tables need to be thrown out, the building torn down, and all the barkeeps and hookers trying to make a cheap buck off the few people that miraculously manage to win something (by being part of the management most likely) thrown out and rehired at the farm down the road. Then you can get some proper equity investors, instead of gamblers or debt peddlers in different forms.
Well, this got sour quick… lets try another game:
This game is nearly free to play. Occasionally, often around the middle of the night, the casino takes a 100 dollar rake but it’s seldom. Few non-regular players like it when that happens, and the hardworking bartenders gets mad because the liquor doesn’t flow that night. Overall, the old chap running the tables is pretty chilled, friendly and most people have a good time enjoying life, and it’s easy to do pretty much anything if you just dare.
Ten decks of cards are out on the table, two of them blanks or duds with no faces, just white, and four have no Kings, Queens or Jacks. If you buy the barkeep a beer, he’ll give you a dime for every time you don’t draw a dud. If you do, you’ll have to buy him another beer. You can sit there for as long as you want, and the beer is getting cheaper by the hour. You have heard other barkeeps doing this with more money, but getting so angry after losing streaks that they throw the players out that night, who obviously don’t return quickly. This guy hasn’t done it so far. If you decide to go bigger and a little bit more daring, you can instead play Texas Hold’em with one deck randomly assorted from this set, same rules but a dud counts as a zero, and winning with sets or above gives you increasingly expensive drinks. Speaking of which, there’s a lot of really expensive alcohol around, but no one really likes to sell it out for money, but you’ve heard a bottle will go down with the card games a few months from now, and can’t really wait.
It’s getting more and more crowded here these days, since the top bars elsewhere started watering their drinks down pretty badly after the last few parties left them in the red after redecoration because some wannabe rich kids came in and hosed those entire places down with champagne.
This might be harder for you to call, but I think that this is Japan, or what it could be in the future. Sure, the bar is indebted, but those chairs are nice, and the coach that gets you back and forth keep people coming around and ordering. Not expensive stuff, but who needs much more than a good beer?
Japan isn’t watering its drinks down (further monetary easing) very much, it’s still beer though, but if you know what you’re ordering, it’s fine. Try a bit harder and you might get wine. The barkeep gambles aren’t very expensive either way (companies are very attractively valued, some argue for a reason, but honestly, will those reasons be worse than Europe soon?) and might pay off for as long as you don’t get duds (falling government bonds in your diversified portfolio). The really expensive stuff isn’t really their cake (consumption taxes at 5%, no legal gambling, inability to foster entrepreneurship and risk taking, lack of pushes for trade with other Asian nations) so they keep it bottled and out of the real economy, which is a shame by any other measure. The combos on gambles (currency plus potential [“bottled”] growth, good internal market, the region around it growing quickly) can really pay off, but you really have to watch out for those duds (here: sclerotic companies caught in their archaic ways) which draws away a lot of potential when you only have 7 cards to use.
I hope that these examples illustrate a little bit of what I mean with risk assets, and looking at things through their underlying appreciation potential regularly reshapes my ideas of risk assets these days. If the Chinese and Indian economies are growing fast, and gold is very popular with them, gold prices go up and track the same features as risk assets do, and thereby become risk assets regardless of that someone thought about the relative value of precious metals and currencies twenty years ago. This process by its very definition infuses the asset with extra pricey risk, which can be lost, rendering the asset less safe! I can easily see the policy path of Japan and the region it is in leading to Japan once again attracting outside risk capital and fostering strong growth, but then they need to uncork some of their best traits and let them out of the stiff glass collar that is their bureaucracies at all levels and fears of failure.
Keep these two ideas in mind when you look at why seemingly the yen and gold is “uncharacteristically” going up with risk, and the Tokyo stock market follows! Think about these things closer when you ask whether you really want euro longer term on suspecting policy risk being overdone (speculation, no value added) and ask if you might not want to plunk it down in Australian Dollars, yen or gold instead. I have a feeling that different asset classes will increasingly play musical chairs with seats labelled risk assets, safe havens and pure gambles, and knowing just where one asset lands can be extremely lucrative.