Business

Risk Management 2.0: “When You Think of Something, Do the Opposite”, Says Morgan Stanley

Risk management is certainly difficult, and there’s no denying that, especially at a time of diminishing appetite for risk. But how do you manage risk at a time when the markets are exceedingly volatile? Oddly enough, Morgan Stanley analyst Adam Parker, Ph.D. suggests that investors just do the opposite of what they think they should do in a note titled “When You Think of Something, Do the Opposite”.

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Funds miss out on FANG

It certainly sounds like he’s calling for chaos on Wall Street in his March 7 report, but chaos is already here. Indeed, there are lots of times when the markets perform in the opposite direction of what we would expect (although this happens more often with certain hedge fund managers who shall remain nameless). The FANG stocks (Facebook, Amazon, Netflix, Google) of last year are one example.

Many mutual funds missed out on the craze, likely because they thought the euphoria surrounding the names was ebbing when in fact it only increased. As a result, they had a brutal 2015, but enough funds missed out on FANG that there was a clear case against all or most of those four stocks. So should all of those fund managers have done the opposite of what they thought they should do in order to better manage risk?

Risk management at a time when we’re going nowhere fast

At any rate, we had to read Parker’s report to see what he’s talking about. There’s something to be said for writing an attention-grabbing headline, but this follows a report last month titled “Bizarro World and The Bull Case Is No One Has a Bull Case.”

Add or remove risk?

In today’s report, Parker notes that risk management just isn’t easy in general, adding that some investors “do it extremely quantitatively” while others “do it in their head” but that neither technique seems to be working. He thinks that generally, most investors think the market will remain choppy for a time before ultimately landing flat in six to 12 months.

He also echoed his comments from last month, saying that most investors believe that the “probability of the bear case is greater than the probability of the bull case, meaning the probability of a downward slope to this choppy range is material.” He said that sentiment has shifted toward the positive even though the general consensus is that the bear case is more likely than the bull case.

“People are asking if they should take more risk now, but they were more negative last month,” Parker wrote. “If the consensus is right that we will chop up and down – and we have some sympathy for this sentiment – then by the time we feel a little better, we should take off risk, not add some.”

“The new risk management,” according to Parker

As a result, he advises that investors do the opposite of what they think they should do, calling this “the new risk management.” (Are we managing risk or sitting on our hands here?) Indeed, he makes an important observation that the markets are doing the opposite of the consensus, but perhaps a more fruitful approach would be thoughtfully (rather than carelessly) adjusting for volatility and learning that past methods are not working in the current environment. After all, no one can be right all the time.

Interestingly, he goes on to make some suggestions about what investors should do. So should we do the opposite of what he thinks? Is he investing his own money by doing the opposite of what he thinks? Of course we should note that his recommendation about doing the opposite pertains to risk management specifically and not the types of suggestions he has (explained briefly below), but these are some of the questions that are worth asking.

What Parker thinks investors should do

One of his recommendations is to pick the U.S. over other global markets as he thinks the earnings backdrop looks “positive, short of a big change in the dollar/ euro relationship.” He also suggests that investors dip into each of three “buckets”: Defensives, Growth and “Unknown.”

In Defensives, he likes Utilities over Consumer Staples, while in Growth, he likes Healthcare and Consumer Discretionary over Technology. In “Unknown,” he prefers Financials over Energy, describing this group as those requiring “accurate forecasting of the 10-year yield and the oil price,” which he sees as “virtually impossible.”

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