Hedge Funds and the Stock Market

On Tuesday an appearance by hedge fund manager David Tepper on CNBC appeared to trigger a rally in the SPX (at least the market began to rally shortly after he declared himself bullish). He presented a chart on the occasion  from a recent NY Fed research paper on the so-called 'equity risk premium'. Reportedly a number of bulls just love this chart (if Business-Insider is to be believed). This rationalization holds however no water – for the simple reason that the basis for calculating the 'risk premium' for equities is simply a variation on the so-called 'Fed model'. In short, the 'risk-free' interest rate is used as the major input in the calculation. Since this interest rate is heavily manipulated by the Fed, this is like saying: “stocks are cheap because the Fed is manipulating interest rates”. This strikes us as a fundamentally wrong way of looking at this.

 

One should rather say: “stocks are mispriced because the Fed manipulates interest rates, and may or may not become more so; moreover, the so-called equity risk premium indicator is completely meaningless in forecasting future stock market returns”.

How meaningless and potentially dangerous this indicator is when evaluating stock prices was amply demonstrated in Japan for well over 20 years after the 1980s bubble burst. John Hussman has written entire compendiums showing how erroneous the approach of the 'Fed model' is. This is a debate that should be well and truly over by now, but here it gets warmed up again, by people who are presumably not entirely free of bias at this point in time (i.e., they are talking their book). We would also point out that e.g. in terms of 'Tobin's Q ratio' (the replacement cost of corporate assets compared to their market valuation), the market is just as overvalued as it was in 1929, 1968 and 1987. Only in 2000 was an even higher level of overvaluation recorded.

 


 

equity premium
The 'equity risk premium', which supposedly proves that stocks are cheap. In reality, it proves precisely nothing.

 


 

Fund Manager Surveys and Presentations

There has been more interesting information emanating from hedge fund land.  The latest Merrill Lynch fund manager survey was released and contained the following interesting data points:

 

“Money managers are the most bearish on commodities in more than four years as a majority expected a weaker Chinese economy for the first time in 14 months, a Bank of America Corp. survey showed.

A net 29 percent of the fund managers surveyed were underweight the asset class in May as their positions “collapsed” to the lowest level since December 2008. One in four now consider a “hard landing” in China as the biggest risk to their investments. The bank surveyed professional investors who together oversee $517 billion.

[…]

Respondents bought Japanese stocks for a seventh-consecutive month, bolstered by the Bank of Japan’s quantitative-easing program. A net 31 percent were overweight the country, the highest proportion in seven years. Even so, that is only half of the peak allocation in December 2005.

Hedge funds’ net exposure to equities climbed in May to plus 45 percent, the highest level in almost seven years. So-called liquidity conditions were the best in more than five years, according to the survey.

Investors’ allocation to banks also rebounded this month, with a net 14 percent overweight the industry, the largest proportion among fund managers since December 2006.

Holdings in U.S. equities remained unchanged at 20 percent overweight, while holdings in euro-area stocks stayed at 8 percent underweight for a second month. The total allocation to equities fell for a second consecutive month to a net 41 percent overweight from 47 percent in April.”

 

(emphasis added)

Almost needless to say, when the rally in Japanese stocks began late last year, almost none of these luminaries had a farthing allocated to Japanese stocks. We wrote about Japan representing a contrarian opportunity at the time. The article began with these words:

 

“Japan's stock market has been in the grip of a secular bear for so long, it appears a true capitulation has by now occurred – and if it hasn't, then it cannot be too far away.”

 

We only mention this because it may be a hint that the current 'underweight commodities and China' stance by hedge funds may turn out to be misguided as well. That does of course not mean that either of these markets will immediately begin to rise. After all, the good timing (November 13) of our article on Japanese stocks quoted above was sheer luck; we had already mentioned them favorably on an earlier occasion, after which they went sideways for many months.

Patience may therefore be required, but it is interesting to know that so much money is now allocated to equities while it has completely deserted commodities and Chinese stocks.

We would stress again that as long as central banks continue to print all-out, there is no telling what asset class the flood of money will spill into next. We generally prefer considering assets that appear relatively cheap and unloved, while acknowledging that the 'herd' can of course be right for considerable stretches of time. Moreover, whether commodities are more likely to fall or rise in the near term is certainly open to debate – global economic fundamentals do not support a rally at this time, but then again, equities have proved capable of rallying on nothing but monetary fumes as well.

 

The Skeptics

There are a number of fund managers that are very rigorous in their estimation of risk, which often means that they will miss out on some upside in 'bubble phases', but they also won't be caught with their pants down when the party eventually ends (and for the record, we believe that when the current party ends, it will do so rather spectacularly and swiftly).

One of those  is Seth Klarman's Baupost, which has recently announced that it will once again return capital to investors because it cannot find anything worth buying (the last time Baupost did that, the financial crisis soon began). Another one is GMO, Jeremy Grantham's shop. GMO has just made it known that it has gone to a 50% cash allocation:

 

“James Montier said that GMO’s 7 year asset allocation model for US stocks is now predicting negative returns. GMO are now 50% in cash.  While they've been known to hold higher levels of cash than most investors, this seems to be taking things a step further. They still hold some investments in Japan but he  indicated that they are likely to be selling over the next couple of months.

He said that a year ago the model was indicating good returns in Europe but now it only suggests  2.5% real return per annum. He said that they are a bit frightened to follow the model in Europe  because of the leverage at the company level, particularly in the financial sector.”

 

(emphasis added)

Incidentally, John Hussman's model of future equity market returns has been giving off alarm signals for some time as well. Obviously, neither Mr. Hussman nor the people at GMO are big believers in the 'Fed model' and rightly so. We think the defensive stance adopted by the handful of outliers – GMO, Baupost and Apollo the most prominent among them – represent a medium term warning sign. These are all fund managers who have correctly identified dangerous junctures before – and they were in the minority on those occasions as well.

 

What Could End the Party?

In recent months, money printing has obviously overruled a rather sobering fundamental backdrop of falling earnings growth and outright economic contraction in several parts of the world. One may well ask what could therefore possibly disturb the happy consensus. In this context, we believe that investors would do well to keep a very close eye on both the yen and the JGB market. The danger is that these markets will 'get away' from the BoJ and that it will turn out it doesn't have them under 'control' after all. There are already rumors (unconfirmed, but plausible) that the rise in volatility in the JGB market is playing havoc with the derivatives books of Japanese banks. As noted yesterday, the JGB market has broken a first level of lateral support recently. The break is not very big yet, but every big move starts out small.

Apart from Japan, we believe the euro area also continues to deserve attention, even though it appears so far as if Super-Mario's 'OMT' promise has successfully put a lid on the crisis. Nevertheless, economic fundamentals in euro-land remain atrocious and there is evidently a growing rift between the ECB and Germany that could lead to a reassessment of the situation.

 


 

JGB-2
The JGB's recent break of support. Overnight, there has been a small rebound – we will see if the former support line now turns into resistance – click to enlarge.

 


 

yen
The yen's relentless collapse (this time viewed in the 'normal' notation that shows how many yen are required to buy one US dollar) – so far the markets 'like' it, but that could change if it becomes even more extreme – click to enlarge.

 


 

Spain, 10-year
Spain's 10 year government bond yield. The recent bounce looks like a routine move, i.e., noise. However, as this chart also shows, the market's perceptions are fickle and can turn on a dime – click to enlarge.

 


 

Conclusion:

The stock market is very stretched to the upside, but the trend remains up for now. Monetary conditions still favor the bulls, but ample liquidity cannot guarantee that a specific asset class outperforms – one must therefore be careful not to read too much into this. As shown in Part 2, a more than 200% expansion in US money TMS-2 since the year 2000 has resulted in stocks losing ground in real terms and essentially going nowhere in nominal terms.

Apart from being technically 'overbought', the market also suffers from too great a unanimity of opinion and too heavy long-side positioning by funds and speculators. While this does not tell us when and from what level a reversal of the trend can be expected, it does tell us that there will be a great many speculators trying to exit all at once. In addition, numerous potential 'gray swans' are lying in wait – risks that are known, but are widely ignored while they keep growing.

 

 

Charts by: NY Fed, Bloomberg, Stockmaster.in


 

 
 

Emigrate While You Can... Learn More

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Gold – An Overview of Macroeconomic Price Drivers
      Fundamental Analysis of Gold As we often point out in these pages, even though gold is currently not the generally used medium of exchange, its monetary characteristics continue to be the main basis for its valuation. Thus, analysis of the gold market requires a different approach from that employed in the analysis of industrial commodities (or more generally, goods that are primarily bought and sold for their use value). Gold's extremely high stock-to-flow ratio and the main source of...
  • Doomsday Device
      Disappearing Credit All across the banking world – from commercial loans to leases and real estate – credit is collapsing. Ambrose Evans-Pritchard writing for British newspaper The Telegraph:   Credit strategists are increasingly disturbed by a sudden and rare contraction of U.S. bank lending, fearing a synchronized slowdown in the U.S. and China this year that could catch euphoric markets badly off guard. Data from the U.S. Federal Reserve shows that the $2 trillion market...
  • India – Is Kashmir Gone?
      Everything Gets Worse  (Part XII) -  Pakistan vs. India After 70 years of so-called independence, one has to be a professional victim not to look within oneself for the reasons for starvation, unnatural deaths, utter backwardness, drudgery, disease, and misery in India. Intellectual capital accumulated in the West over the last 2,500 years — available for free in real-time via the internet — can be downloaded by a passionate learner. In the age of modern technology, another mostly...
  • Pulling Levers to Steer the Machine
      Ticks on a Dog A brief comment on Fed chief Janet Yellen’s revealing speech at the University of Michigan. Bloomberg:   “Before, we had to press down on the gas pedal trying to give the economy all of the oomph that we possibly could,” Yellen said Monday in Ann Arbor, Michigan. The Fed is now trying to “give it some gas, but not so much that we’re pushing down hard on the accelerator.” […] “The appropriate stance of policy now is closer to, let me call it...
  • Credit Contraction Episodes
      Approaching a Tipping Point Taking the path of least resistance doesn’t always lead to places worth going.  In fact, it often leads to places that are better to avoid.  Repeatedly skipping work to sleep in and living off credit cards will eventually lead to the poorhouse.   Sometimes the path of least resistance turns out to be problematic   The same holds true for monetary policy.  In particular, cheap credit policies that favor short-term expediency have the...
  • Cracks in Ponzi-Finance Land
      Retail Debt Debacles The retail sector has replaced the oil sector in a sense, and not in a good way. It is the sector that is most likely to see a large surge in bankruptcies this year. Junk bonds issued by retailers are performing dismally, and within the group the bonds of companies that were subject to leveraged buyouts by private equity firms seem to be doing the worst (a function of their outsized debt loads). Here is a chart showing the y-t-d performance of a number of these...
  • Mea Culpa – Precious Metals Supply and Demand
      Input Data Errors Dear Readers, I owe you an apology. I made a mistake. I am writing this letter in the first person, because I made the mistake. Let me explain what happened.   The wrong stuff went into the funnel in the upper left-hand corner...   I wrote software to calculate the gold basis and co-basis (and of course silver too). The app does not just calculate the near contract. It calculates the basis for many contracts out in the distance, so I can see the...
  • French Election – Bad Dream Intrusion
      The “Nightmare Option” The French presidential election was temporarily relegated to the back-pages following the US strike on Syria, but a few days ago, the Economist Magazine returned to the topic, noting that a potential “nightmare option” has suddenly come into view. In recent months certainty had increased that once the election moved into its second round, it would be plain sailing for whichever establishment candidate Ms. Le Pen was going to face. That certainty has been...
  • The Cost of a Trump Presidency
      Opportunity Cost Rears its Head Last Thursday’s wanton attack on a Syrian air field by the US and its bellicose actions toward North Korea have brought the real cost of candidate Trump’s landslide victory last November to the forefront.   It didn't take long for Donald Trump to drop his non-interventionist mask. The decision was likely driven by Machiavellian considerations with respect to domestic conditions, but that doesn't make it any better.   Unlike...
  • Heavily Armed Swamp Critters
      Worst Mistake GUALFIN, ARGENTINA – By our calculation, it took just 76 days for President Trump to get on board with the Clinton-Bush-Obama agenda. Now there can be no doubt where he’s headed. He’s gone Full Empire. Not that it was unexpected. But the speed with which the president abandoned his supporters and went over to the Deep State is breathtaking.     Once there was only a Trump fragrance called Empire... now he has gone full empire himself   Among the noise...
  • Hell To Pay
      Behind the Curve Economic nonsense comes a dime a dozen.  For example, Federal Reserve Chair Janet Yellen “think(s) we have a healthy economy now.”  She even told the University of Michigan’s Ford School of Public Policy so earlier this week.  Does she know what she’s talking about?   Somehow, this cartoon never gets old...   If you go by a partial subset of the ‘official’ government statistics, perhaps, it appears she does.  The unemployment...
  • Trump Is An Insider Now
      Conspiracy of the Few GUALFIN, ARGENTINA – “U.S. stocks fall on Trump talk…” began a headline at Bloomberg. Or it may be Trump action. We had already counted six major campaign promises – including no O’care repeal and no “America First” foreign policy – already buried (some for the better).   A bunch of campaign promises get the MOAB treatment...  A great many  theories have been proposed to explain Trump's recent series of u-turns: 1. he is in thrall to...

Support Acting Man

Austrian Theory and Investment

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com