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It's about time Wall Street recognizes some of its own risks

| Sunday, July 29, 2007

The worst risk is the one you do not recognize or fail to acknowledge.

The repricing of risk was one of the common explanations for the stocks market's dive Thursday that erased 331.5 points from the Dow Jones Industrial Average and 35.4 points from the S&P 500 Composite Index. This was the market's way of taking into account risk it previously ignored or did not see. Interestingly, however, as Treasury Secretary Hank Paulsen said in an interview Friday, recognizing these risks probably reduced overall risk in the future.

An old bit of sarcasm that says ignorance is bliss probably applied over the last few months. The market either was willing to ignore some of the credit risks presented by questionable loans or it did not appreciate fully the potential consequences. Blissfully, the Dow and S&P 500 moved to new highs. Moving from blissful ignorance to the stark reality of subprime loan problems and the weakening ability to get private equity deals done finally prompted a "sell first, ask questions later" mentality.

Thursday's 2.23 percent drop in the S&P 500 received widespread news coverage, but it was only the 71st worst day for the S&P since just 1990. Nonetheless, almost regardless of the percentage, a more than 300-point Dow loss gets attention. For anyone that did not recognize any of the underlying risks, Thursday probably was a wakeup call.

Measuring risk is difficult, mainly because increased risk tolerance occurs slowly over a long period.

In stocks, for example, if earnings growth consistently has exceeded estimates, gradually the market prices in the probability that the growth expectations will continue to be beaten farther and farther into the future. This can push price-earnings ratios to dangerously high levels.

The process impacts bonds. The willingness to accept lower-than-usual interest rates for low-rated bonds comes after a long period when none, or only a few, lower-rated issues run into problems.

Often without much, if any, advance notice, one day the market suddenly realizes that something is not right. Although subprime loan problems were well documented and the threat of the problem spreading was well known for weeks, traders last week decided that enough was enough. There was a basis for the market to react to the credit market problems. However, there was an underlying reason to accept increasing risk as the market moved higher.

Somewhat like putting icing on a mold-laden cake, the market often sugar coats problems in a way that makes recognizing a pending sentiment change difficult.

Weeks before last week's drop, the ratio of advancing to declining issues, commonly referred to as market breadth, lagged well behind the Dow and S&P 500 that were setting new highs. Breadth, however, was not the sole indication of internal deterioration.

During the Dow's 149.3-point drop on July 20, breadth was very poor, but that Friday was not the telling session. Breadth last Monday was dismal despite the Dow bouncing back 92 points. Tuesday's 226.47-point drubbing reflected the fact that even the icing on the market's cake was spoiling. The market tried one more time to cover its internal weakness by the Dow posting a 68.12 gain on Wednesday, but breadth again was feeble. The icing finally came off completely with Thursday's 331.50-point drop.

During periods when the market begins to question some of its prior assumptions, it is important to remember that all of them were not wrong. They just might have been taken too far.

Second-quarter earnings growth is meeting the expectation that upside surprises would be nearly as common as they had been for many prior quarters. Second-quarter Gross Domestic Product growth was better than estimates that had called for growth to be nearly five times what it was in the first quarter.

It is important to remember that when the market reassesses some of its prior beliefs, often the process goes to an extreme as prior beliefs completely are cast aside. This is just as wrong as sentiment was when the market blissfully ignored problems.

At this point, the market has to find a happy medium. Friday's trading that even at its worst did not push the S&P 500 below Thursday's intraday low made some progress toward an equilibrium point.

Clearly the market has shown that it now recognizes some of the credit risks it ignored before, and, as Secretary Paulsen suggested, going forward this awareness on its own could make the market less perilous.

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