A Global Repricing of Risk

Kurt Brouwer July 26th, 2007

Stock markets around the globe tumbled today as investors took a fresh–and apparently harrowing–look at risk in the financial markets. The Dow Industrials suffered the worst loss of the year, falling over 311 points or 2.26% for the day. The S&P 500 fell 2.33%. On the other hand, jitters in the credit markets led to a flight to quality as Treasury bond prices gained significantly and, conversely, the yield on Treasuries fell.

Eric Martin at Bloomberg reports on the widespread losses around the globe [emphasis added]:

‘Stocks tumbled around the world and U.S. Treasuries rallied on concern higher borrowing costs will slow takeovers, spur debt defaults and curb earnings, prompting investors to flee riskier assets.

The Dow Jones Industrial Average and Standard & Poor’s 500 Index fell the most since February, while the FTSE 100′s biggest drop in four years led declines across Europe. Benchmark stock indexes in Argentina, Brazil, Mexico, Turkey and Sweden sank more than 3 percent.

We’re seeing a global repricing of risk as the cost of capital ratchets up,” said Joseph Quinlan, chief market strategist at Bank of America’s investment strategy group in New York,…’

Mr. Quinlan’s point is a good one. This really is a day in which stock market investors around the globe turned gloomy. Now, it is important to recognize that for every stock that is sold, there is a corresponding buyer. So, some investors are taking this opportunity to pick up what they believe are bargains.

For the past year or more, bonds have not been exciting investments. Interest rates have steadily increased, but suddenly bonds are doing well as interests rate on high quality bonds fall. The Bloomberg story continues:

‘… As investors grew skittish about corporate bonds they put more money into Treasuries. The yield on the benchmark 10-year note fell 11 basis points, or 0.11 percentage point, to 4.79 percent in New York, according to bond broker Cantor Fitzgerald LP, the lowest in two months…’

This is a good example of how diversification works–and does not work. Stocks around the globe fell today so the distinction between domestic stocks and foreign stocks did not matter as much as it has recently. However, bonds gained even though stocks were falling. That’s what they are supposed to do.

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