The stock market has posted a solid start to the year, with the S&P 500 up some 6.5% in January and February. The reason (at least in part) is—risk.

That four-letter word is good news for a market that, since the financial crisis, has been beleaguered by “complete uncertainty”—which left many investors with the sinking feeling that the proverbial shoe was always ready to drop. To counter the undercurrent of impending doom (real or imagined), the Fed, the Treasury, and central banks around the world essentially propped up the market.

When risk is visible, it can be measured, evaluated, mitigated, managed, and hedged (at least to some degree). And where there is risk of the visible variety, there is also the potential for reward.

Let’s take a simplified example. Say you have $20,000 to invest. If, based on visible risk, you determine that the most you stand to lose is 10% or even 20%—whatever the potential downside might be—then you can make an investment decision accordingly. You might decide to invest all of it and risk $2,000 or $4,000 (depending upon the magnitude of risk that you foresee), or you may decide to invest a portion—say, $10,000 and risk a potential loss based on your analysis of $1,000 or $2,000. (Hopefully, the potential on the upside more than offsets that risk, of course.)

The point is, with a better handle on the potential downside, and being able to tie actual reason to what’s behind potential risk, investors have been committing more to the market, as we’ve seen with the Dow hovering at all-time highs over the 14,000-mark.

The one caveat on visible risk is that it is—well, risk. Without the Fed-administered training wheels to guide the market through the bumps, now when risks are detected the market will react—for real. Therefore, should there be a significant change in the economic picture, there could potentially be a 20-25% correction lasting two to four quarters. This is not a prediction—just a potentiality.

With visible risk, we also expect the market to be more responsive to economic fundamentals than it has in recent years when intervention basically clipped the tails. This is a far healthier environment, at least from a fundamental, tactical asset management approach.

The dominant reality for 2013 is all about whether we will see a pickup in demand. Since the financial crisis, demand has been crimped as consumers dealt with hangovers caused by pre-crisis overindulgence. The good news, we believe, is that there is pentup demand, particularly for capital spending. A revision in Q4 2012 GDP brought the reading to +0.1% from -0.1%. The ISM’s manufacturing purchasing managers’ index increased to 54.2 in February from 53.1 in January. Thus far, sequestration has had less impact on the market than many people thought because of drama fatigue. In housing, some improvements point to potential good buying opportunities on corrections in the right sectors. At the same time, investors should be cautious when it comes to oil and other commodities.

Not all the economic data, however, has been promising. The Philadelphia Fed Business Index worsened and fell into contraction territory in January, while construction spending posted an unexpected decline in January. The point being we’re not pushing the envelope on growth right now. Whatever occurs—an accelerating economy or a sudden contraction—the market will react accordingly, based on visible risk. (Beware that just because the return of visible risk was hailed by a market that moved higher, don’t expect that to always be the case.)

Risk is back, with its potential to move the market in either direction. After the past few years of complete uncertainty and market intervention, this is a welcome sign, indeed.

– Rob Stein

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