"Socrates, Yogi Berra, And Donald Rumsfeld Walk Into A Bar..."

Authored by Danielle DiMartino Booth via QuillIntelligence.com,

  • With stocks at all-time highs, any significant correction will have a devasting effect on the 55% of boomers who have retirement savings; of the 10,000 boomers retiring daily 1,500 have at best two years of living expenses while 4,000 will be living solely off Social Security

  • University of Michigan data isolates a source of risk to the business outlook households perceive but can’t articulate which has spiked recently; “Background Risk” which cannot be avoided or diversified has become the second largest driver of recession odds

  • Even with spreads a third narrower since December, the junk bond market issued $13B of new paper last week, a two-year high; spreads for the lowest-rated junk bonds, ‘CCC,’ have only narrowed by 11% from the end of last year indicating that taking on risk has its limits

Heresay is all we get when it comes to Socrates. But we take what we can get because it’s so good. With that, according to Plato, Socrates coached hubristically inclined mortals as such:

“I only know that I don’t know anything.”

Some 1,600 years after his untimely death in 399 B.C., the philosopher Ibn Yami categorized this thinking. We’d like to focus today on Yami’s third level of actualization:

One who doesn’t know, but knows that he doesn’t know... his limping mule will eventually get him home.” 

Or if you prefer the over-cooked version of this adapted in the modern era by Donald Rumsfeld, the “known unknowns,” things we’re aware of, but can’t fathom, or in one word – risk.

In the canyons of Wall Street, traders are paid based on their knack for gauging real-time risk. Throughout America, mom and pop investors are rewarded based on their ability to anticipate the megacycles elongated by the Federal Reserve. There are millions of baby boomers who would have long since retired if they hadn’t been wiped out by the busts that followed booms in their adult lives. The exceptions are those who were willing to cash out early and got back in, a.k.a. the lucky few.

Today, countless members of this same cohort live in more home than they can afford to carry into retirement and don’t have the luxury of time to wait out their stock portfolio’s next body blow. As per fresh data out of the Insured Retirement Institute, of the 55% of boomers who have retirement savings, one-in-four have less than $100,000The Bureau of Labor Statistics reports that those 65 and older spend $48,885 a yearQuick math dictates that 15% of the 10,000 boomers retiring daily have at best two years of living expenses while 40% will immediately be living solely off Social Security. With that as a backdrop, how would a 56% decline in the S&P, matching the last downturn, go over?

It’s no secret that acute overvaluation heightens the odds of a financial event, whether the trigger is a drone attack or a massive strike at a Big 3 automaker. The problem is neither of these contingencies were known knowns as of the close of trading Friday.

This somewhat Socratic exercise brings us to some micro data via the University of Michigan. Every month, those surveyed are asked about the source of bad news they’re hearing about changing business conditions. The categories include government/elections, unemployment, lower consumer demand, higher prices, tighter credit, energy crisis, stock market or trade/global economy. And then there is the unknown, the factor making things worse that households just can’t articulate even though they know it’s there. As you can see on the blue line above, the last two months have seen a spike in unidentifiable risk.

A parallel gauge backs this growing anxiety. According to J.P. Morgan, the largest contributor to the current 45% probability of recession striking within a year is Historical Average, at 17%. Add up the other economic components and you get to 33%. And then there’s  “background risk,” which at 12% is the second largest driver of recession odds. As per Google, “Background risk is risk that cannot be avoided or diversified…(it) makes people less willing to take other independent risks.” QI’s Dr. Gates sagely asked, “Got trade war?”

We would add that high yield investors’ fear of the unknown is heightened despite its intangibility. To much fanfare, corporate bond issuance has been on fire. The party has extended to the junk bond market where companies sold $13 billion of bonds last week, a two-year highThe premiums investors pay over comparable maturity Treasuries have narrowed by nearly a third, to 365 basis points (bps) from 526 bps at the end of last year.

The same cannot be said of ‘CCC’ junk bonds, the last rung on the credit rating scale before an issuer defaultsSpreads have come in 11%, to 878 from 989 in December and averaged an elevated 821 bps over the past 12 monthsWe don’t deny that the trade has been “Risk On” but only up to a point.

As QI friend Peter Cecchini of Cantor Fitzgerald wrote recently, junk bond investors are buying “pure froth” as leverage pushes seven times EBITDA at a growing number of firms while that same EBITDA equates to less than 1.5 times annual interest expenses. We concur with Bloomberg’s choice of a closing quote from Cecchini’s:

“It’s unclear what the catalyst for a severe sell-off might be, but we don’t expect more spread compression.”

The outlook overall is clearly “unclear” for a growing number of investors, big and small. But just because you can’t identify the risk doesn’t mean it’s not there.