If you're waiting for the next meltdown in US stocks or in commodities, you may want to get over it.
After several false dawns following the global financial crisis, more investors are starting to believe the current rally in stocks, commodities and emerging markets could be a long-lasting one.
The S&P 500 .SPX closed above 1,400 points last week for the first time since the 2008 financial crisis. Investors piled into US equity funds, with the biggest weekly inflows since mid-September.
"Is this risk rally for real? I think the answer to that question is yes, but it's not a straight line up," said Art Steinmetz, chief investment officer at Oppenheimer Funds in New York, managing more than $177 billion in assets.
Oppenheimer is currently betting on stocks tied to upswings in the economy, and is also overweight in riskier bond classes, he said.
Since its recent bottom in early October, the S&P index has jumped 30 per cent. But for the first time since 2007, investors are not using the gains as an opportunity to take profits and run away. Instead, the rally has been slow and steady, and investors see the sustained improvement in the US economy as a sign that demand has returned and that risky assets can support higher valuations.
"The prospects for future returns in equities relative to bonds are as good as they have been in a generation," Goldman Sachs in a note Wednesday said.
Dean Junkans, chief investment officer at Wells Fargo Advisors and Wells Fargo Private Bank, said individual investors have started wading back into higher-risk, higher-yield assets, including high-yield and emerging market funds.
"For the last five years, few people wanted to talk about a long-term plan," said Junkans, who oversees $1.3 trillion in assets. Instead, investors had preferred the safety of low-yielding Treasury bills and money market funds.
"Now I'd say they are dipping their toes back into the market," he said, citing demand for high-dividend-yield stocks, high-yield corporate debt, and emerging market fixed income.
How Risky Assets Have Performed
Last year was one for the risk-averse: US government bonds were the best-performing asset class. This year has been the reverse.
The S&P is already up 11 per cent in 2012. The Thomson Reuters-Jefferies commodity index .CRB has gained 2.4 per cent so far in 2012 after losing more than 8 per cent last year. Long-dated US Treasuries prices, meanwhile, are down 7.3 per cent this year, according to Barclays Capital.
The euro, at the epicenter of the financial crisis, is also up nearly 2 per cent against the dollar in 2012 after losses of 3.2 per cent in 2011.
"There has been very substantial progress in the euro zone the last couple of months," said Thomas Stolper, chief currency strategist at Goldman Sachs in London. He expects the euro to hit $1.38 over the next six months and $1.45 by the end of 2012.
The euro zone's general stability is reflected in currency options as well. Implied volatility has fallen to levels not seen since before the euro zone debt crisis, in large part because heavily indebted Greece finally agreed to a bailout plan and debt restructuring and the European Central Bank offered short-term loans to the region's banks.
The high-yield debt market has risen more than 5 per cent this year, according to Barclays Capital. Investors have flocked to junk bond ETFs, with the two largest junk-bond ETFs attracting nearly half of the $4.15 billion that flowed into US fixed income in February.
Emerging markets have also become more popular: The Vanguard MSCI Emerging Markets ETF pulled in $2.5 billion while the iShares MSCI Emerging Markets Index Fund hauled $1.5 billion, according to IndexUniverse.com, which tracks ETF performance.
Finding Comfort In Risk
The US stock market is a favorite of Scottish Widows Investment Partnership. The fund, which is based in Edinburgh and manages about $220 billion, has made US stocks the biggest overweight sector in its portfolio.
"The recovery in the US has been more robust than expected, and the rally in the US is probably more durable," said William Low, head of global equities at Scottish Widows. The firm has exposure to US industrials, information technology, and the consumer discretionary sector.
A key measure of risk suggests more investors are becoming comfortable with equities as the rally has continued. The implied equity risk premium, which compares the market's earnings yield - a ratio of earnings to share price - to the yield on risk-free government debt, is what investors are willing to pay to invest in stocks instead of bonds.
When it rises, it suggests investors want to be paid more to take on the risk of owning stocks. When it falls, it suggests more comfort with equities.
Over the last 10 years, risk premiums in both the United States and Europe have been rising. Premiums peaked in August 2011 and have since been declining, an indication that investors are more positive on the outlook for stocks.
The implied risk premium currently suggests another 10 to 15 per cent in gains in the US stock index this year, and for European equities, a further 6-8 per cent rise.
Skepticism Still Out There
It is easy to be skeptical about this year's gains. Risky assets have gone through a series of rallies that were undermined by worries, ranging from the euro zone's debt crisis to the Japanese earthquake and sluggish performance from banks.
In Europe, while Greece has negotiated a bailout program and a debt restructuring agreement, investors question whether it will be the end of the region's troubles. Other indebted nations like Spain and Portugal loom as problems for Europe's banks.
Saber-rattling between Iran and Israel has boosted crude prices. Rising gasoline costs could pinch consumer budgets, and a greater conflict would add uncertainty to markets.
In addition, recent data has rekindled fears that the euro zone could fall back into recession. And signs of slowing growth in China could carry risks around the world, particularly commodities-rich countries from Latin America to Australia that have found a rich market in China for their goods.
This year's strong rally has led some, like London-based hedge fund GLC, to reduce their exposure to risk after profiting from stock-market gains and successful bets against bonds.
Nonetheless, Steven Bell, director and portfolio manager for GLC, which has about $1 billion in assets under management, does not see a bear market coming. "We're still on a positive track and in a bullish trend," he said.
Other funds are taking advantage of low volatility to increase hedges against calamitous events. The CBOE Market Volatility Index, or VIX .VIX, Wall Street's favored anxiety gauge, last week hit its lowest close since mid-2007, suggesting benign market conditions will continue.
But later-dated volatility futures contracts show increased concern that the market is starting to become complacent. Similarly, currency market investors are also hedging against unforeseen outcomes. The concern is that the euphoria will leave investors exposed to sudden, sharp declines.
Still, the market's worries are less intense when compared with 2008, when Lehman Brothers collapsed, or the euro zone crisis that dominated 2011.
"Markets love a grizzly story," said Simon Smollett, senior currency options strategist at Credit Agricole in London. "But there is no grizzly story. The bears have left the room."