Central Banks' extreme interventionist policies (whether direct money-printing or indirect subordination of existing risk-takers) has left an investing public with a very different risk-reward environment (and very different forecast distributions for future outcomes) as we pointed out earlier [6]. As Matt King of Citigroup notes, the 'risk-on risk-off' environment is here to stay meaning the traditional safety of bonds now offers even less upside and more downside (thanks to subordination) and equities or higher-beta more upside (thanks to central banker puts under asset markets). This helps explain the portfolio-rebalancing effect of QE et al. However, this leads to a focus on high-beta momentum with a growing chasm between price and value - and more likelihood of catastrophic loss when risk-goes-off (as liquidity spigots are closed however temporarily). Efficient frontiers are now not so efficient with marginal returns now perceived as accelerating for incremental risk-taking as the Fed has your back. This means market-cap weighted indices will naturally favor the highest-beta (much more volatile) names that will suffer the most when risk re-appears - so focus on equal-weighted or fundamental-weighted indices for risk-balanced-return. Trying to be long the tails is key as central bankers repress normal investors away from core safety leaving behind the precipice of over-invested, over-risk-stuffed momentum chasers holding the bag.
How Forecasts Have Changed - the distribution of growth probabilities has changed dramatically...
[7]
And to repress investors from worrying about these tails, central banks have printed money to nominally raise asset prices and have 'supported' debtors by subordinating existing creditors...this has increased upside for equity holders (as the central bank put seems prevalent) and increased downside for bond holders (as whatever support is provided seems to subordinate existing holders in order to avoid an actual restructuring)...
[8]
Which turns the efficient-frontier on its head - with upside from taking more and more risk an accelerating function as opposed to decaying option - i.e. investors are expecting exponentially higher marginal returns for taking on linearly more risk - since the Fed has their back. It seems being long the tails is a more balanced strategy than it used to be...
[9]
Source: Citi