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.
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.”
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.
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.”
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.
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'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.
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
It is that time of the year again – our semi-annual funding drive begins today. Give us a little hand in offsetting the costs of running this blog, as advertising revenue alone is insufficient. You can help us reach our modest funding goal by donating either via paypal or bitcoin. Those of you who have made a ton of money based on some of the things we have said in these pages (we actually made a few good calls lately!), please feel free to up your donations accordingly (we are sorry if you have followed one of our bad calls. This is of course your own fault). Other than that, we can only repeat that donations to this site are apt to secure many benefits. These range from sound sleep, to children including you in their songs, to the potential of obtaining privileges in the afterlife (the latter cannot be guaranteed, but it seems highly likely). As always, we are greatly honored by your readership and hope that our special mixture of entertainment and education is adding a little value to your life!
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
Most read in the last 20 days:
- Gold Price Skyrockets in India after Currency Ban – Part III
When Money Dies In part-I of the dispatch we talked about what happened during the first two days after Indian Prime Minister, Narendra Modi banned Rs 500 and Rs 1000 banknotes, comprising of 88% of the monetary value of cash in circulation. In part-II, we talked about the scenes, chaos, desperation, and massive loss of productive capacity that this ban had led to over the next few days. Indian prime minister Narendra Modi – another finger-wagger, as can be seen in this...
- Gold Price Skyrockets in India after Currency Ban – Part II
Chaos in the Wake of the Ban Here is a link to Part 1, about what happened in the first two days after India's government made Rs 500 (~$7.50) and Rs 1,000 (~$15) banknotes illegal. They can now only be converted to Rs 100 (~$1.50) or lower denomination notes, at bank branches or post offices. Banks were closed the first day after the decision. What follows is the crux of what has happened over the subsequent four days. India's prime minister Nahendra Modi, author of the...
- Gold Price Skyrockets in India after Currency Ban – Part IV
A Market Gripped by Fear The Indian Prime Minister announced on 8th November 2016 that Rs 500 and Rs 1,000 banknotes would no longer be legal tender. Linked are Part-I, Part-II and Part-III updates on the rapidly encroaching police state. The economic and social mess that Modi has created is unprecedented. It will go down in history as an epitome of naivety and arrogance due to Modi’s self-centered desire to increase tax-collection at any cost. Indian jewelry...
- A Note on Gold and India – What is Driving the Gold Price?
Hidden Motives It is well-known that India's government wants to coerce its population into “modernizing” its financial behavior and abandoning its traditions. The recent ban on large-denomination banknotes was not only meant to fight corruption. Obviously, this very bad Indian has way too much cash. Just look at him, he looks suspicious! Photo via thenewsminute.com In fact, as our friend Jayant Bhandari has pointed out, fresh avenues for corruption ...
- Will Trump Do What Reagan Couldn’t?
Depravity and Degeneration BALTIMORE – Finally, it’s over. We were both delighted and appalled by the news. A smile spread over our face... and our steps lightened... as we looked ahead to four years without Hillary Clinton’s know-it-all mug in the news. Praise be! This mug will be largely missing from the airwaves and the intertubes in coming years. And your caption scribbler PT won't have to look for a fall-out shelter! We thank the Lord and the American public for...
- India's Currency Debacle – An Interview with Jayant Bhandari
A Major Crisis Last week Jayant Bhandari related the story of the overnight ban of certain banknotes in India under cover of “stamping out corruption” (see Gold Price Skyrockets In India after Currency Ban Part 1 and Part 2 for the details). Banned 500 rupee banknotes The problem is inter alia that the sudden ban of these banknotes has hit the Indian economy quite hard, given that 97% of all transactions in the country are cash-based. Not only that, it has...
- Inflation Expectations Rise Sharply
Mini-Panic Over Inflation After Trump's Election Victory We have witnessed truly astonishing short term market conniptions following the Donald Trump's election victory. In this post we want to focus on one aspect that seems to be exercising people quite a bit at present, namely the recent surge in inflation expectations reflected in the markets. Will we have to get those WIN buttons out again? A 1970s “whip inflation now” button. The only thing that was actually needed...
- Will the Swamp Swallow Trump?
Permanently Skewed TRUMP HOTEL, New York – Trump’s rambling army – professionals, amateurs, camp followers, and profiteers – is marching south, down the I-95 corridor. There, on the banks of the Potomac, it will fight its next big battle. Lieutenants in Trump's army: Bannon, Flynn & Sessions Photo credit: Drew Angerer / AFP Here at the Diary, we do not like to get involved in politics. But this is a special time in the history of our planet – a...
- There Are Two Types of Credit — One of Them Leads to Booms and Busts
Stumped by the Bust In the slump of a cycle, businesses that were thriving begin to experience difficulties or go under. They do so not because of firm-specific entrepreneurial errors but rather in tandem with whole sectors of the economy. People who were wealthy yesterday have become poor today. Factories that were busy yesterday are shut down today, and workers are out of jobs. What has caused the bust? The modern-day economic orthodoxy continues to be unable to provide...
- All Aboard! Trump’s Express Train to the Future
Free Money! BALTIMORE – Last week, the Dow punched up above 19,000 – a new all-time record. And on Monday, the Dow, the S&P 500, the Nasdaq, and the small-cap Russell 2000 each hit new all-time highs. The last time that happened was on the last day of December 1999. Ironically, two events that were almost universally expected to trigger large stock market declines were followed by quite rapid and strong gains. Would the market have fallen if Hillary Clinton had won...
- Gold Bull Market Remains Intact – Long Term Fundamentals Outweigh Short Term Market Gyrations
A Strong First Half of the Year, Followed by Another Retreat In early 2016 gold had a big bull run. The precious metal rose close to 25% this year, pushed higher in a summer rally that peaked on July 10th. Gold experienced a bumpy ride over the remainder of the summer though, as investors became increasingly concerned about a potential rate hike by the Federal Reserve. Uncertainty returned to gold market and has intensified further since then. Initially, gold rallied sharply...
- Too Early for “Inflation Bets”?
The Trump Trade After 35 years of waiting... so many false signals... so often deceived... so often disappointed... bond bears gathered on rooftops as though awaiting the Second Coming. Many times, investors have said to themselves, “This is it! This is the end of the Great Bull Market in Bonds!” The long bond's long cycle – red rectangles indicate when the post 1980 bull market was held to be “over” or “over for sure” or “100% over”, etc. We have...