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
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