Nothing seems to faze the market. Regardless of which market or asset class, the price appreciation continues with little regard for risk. For investors and asset allocators who are actually focused on risk management, this environment can be maddening. When a bull market, like the current one, subscribes to the belief that nothing materially negative can happen, it is abundantly clear that risk is being ignored. Below, we feature three different asset classes – Bitcoin, South Korean equities and U.S. volatility – as case examples. These are not meant to imply that markets will correct or that investors should be fearful. Rather, we highlight these extreme levels of complacency so that RIAs and other asset allocators will proactively analyze the risks hidden within their portfolios. Now is not the time to be lulled to sleep.
Many distinguished economists, asset allocators, risk takers, and the like have by now shared their views on the cryptocurrency. The overwhelming consensus is that there is little fundamental justification for its value and recent astronomical rise. Yet, this has not stopped investors (can we even use this term?) from rushing into the market. One particularly strong and surprising source of demand has been South Korea. It has been estimated that roughly 25% of the volume traded is coming from South Korea, participants that are apparently willing to pay a 16% premium to prevailing international rates (see the Fortune magazine article, "Bitcoin Is Such a Frenzy in South Korea That It Costs More There”). While demand for the cryptocurrency could be understandable in politically-charged countries such as Venezuela, Syria, North Korea, and even China or Russia, it is not clear why Bitcoin has such a disproportionate fundamental demand in South Korea.
Which begs the question - if the concepts of supply and demand drive prices, why has the global demand for Bitcoin suddenly spiked in 2017? Just recently, Bitcoin prices more than doubled in just a month. Since the beginning of the year, Bitcoin prices have increased over 15x! It appears many market participants are unwilling to question the fundamental reasons for the price appreciation.
Speaking of Koreas, North Korea launched yet another missile on November 28, 2017. This time, it was an ICBM class that many analysts believe (and North Korea purports) is capable of reaching any part of the continental United States. Local press insinuated that U.S. officials had contacted their South Korean counterparts and said it can unilaterally strike North Korea. This contradicts a speech by South Korean President Moon Jae in just a few months ago where he said the U.S. promised to seek his permission before striking. Prior to the most recent missile launch, the NY Times published an article, "Slouching Toward War With North Korea", where it cited several experts’ assessment of the odds of a war with North Korea:
- John Brennan, former head of CIA: 20%-25%
- Joel Wit, Korea expert at Johns Hopkins University: 40%
- Richard Haass, President of the Council of Foreign Relations: 50%
Whoa, a 20%-50% probability range??!! For those unfamiliar with the situation, a rekindled war (we are still technically at war but under an Armistice Agreement) has the potential to be utterly catastrophic. Should North Korea retaliate simply with artillery (8,000 cannons pointed at Seoul capable of raining up to 300,000 rounds within the first hour of attack), civilian casualties could ratchet up to hundreds of thousands. This is at the low end of estimates out there.
This begs some questions: what should put options be worth if there is a 20% chance within the next 1 year of the KOSPI (and Korean Won at the same time) being down say 30%? Does the current annualized implied volatility of 24% (per EWY options) seem to accurately price this risk? And is it appropriate that KOSPI continues to trade near all-time highs?
Another important recent geopolitical development is the Trump administration recognizing Jerusalem as Israel’s capital. Without taking sides as to the appropriateness of this move, the ramifications are substantial: it is more likely than not that there will be significant backlash from the Islamic community. The form of backlash is still to be determined; it may or may not take the form of violent outbursts. Regardless, it would be surprising not to see substantive policy responses from the predominant Muslim countries around the world. Yet, the VIX is comfortably at historically low levels of roughly 10%, and the S&P index continues to trade near all-time highs.
The conclusion of the above is not necessarily that the market should decline meaningfully; nor is the intent to harbor or promote fear-mongering. Rather, we are merely pointing out the high level of complacency the market has today across asset classes globally. That dynamic should give RIAs and other international equity investors pause. After all, risk has not disappeared, it’s just being ignored.
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As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF LUIS AHN
Luis Ahn is a Partner and Analyst at R Squared Capital Management.
Prior to joining R Squared, Luis was a Senior Analyst at Bloom Tree Partners.
Luis received an MBA from The Wharton School and Bachelor of Science in Quantitative Economics and Computer Science from Tufts University.
To view the firm biographies of RSQ, click here.