The IMF Conference and Hedge Funds
This was the first IMF conference I have been invited to (and probably the last) and I therefore have little experience of this annual gathering of mostly irrelevant people. However, I have a few observations to make about the IMF meeting.
These events are gigantic in size, and one can only wonder whether the financial markets and the entire financial sector have outgrown their usefulness. Also, huge investors’ conferences are more symptomatic of extremely mature markets or market peaks, than of sectors that offer great buying opportunities. As I have pointed out previously, our industry has far too many treasure hunters and it has become virtually impossible to identify truly unusual investment opportunities.
Moreover, the financial sector is now so huge, the costs associated with maintaining us — the parasites of the real economy — must be astronomical. These costs are, of course, directly or indirectly, borne by the clients and reduce their performance accordingly, since the majority of fund and hedge fund managers do not outperform the stock indexes. In this respect, it is interesting to note that the rather reclusive Steven Cohen of SAC Capital recently expressed in an interview the opinion that “there are no more easy pickings” and that with about 7,000 hedge funds competing for investment ideas, good stock investments are becoming scarce.
According to Cohen, “it’s hard to find ideas that aren’t picked over and harder to get real returns and differentiate yourself. We are entering a new environment. The days of big returns are gone” because the tailwind of low interest rates, low inflation, and strong profits has been lost. Cohen also worries that as hedge funds have become bigger, a sudden rush for the exit could spell trouble. And while not predicting such a decline for this year, he thinks that some time in the future “there will be a real decline that may devastate hedge funds that have crowded into the same stocks”.
While I agree in general with Steven Cohen’s view, I should like to add that “a real decline” will devastate not only hedge funds but the entire financial services industry. For this reason, I continue to argue that, in the long term, the US Federal Reserve has no other option but to print money, and that a decline in asset prices will occur in real terms (inflation adjusted) rather than in nominal terms.
In my opinion, the asset bubbles are simply too big, and so much of the economy depends on them not bursting and seriously deflating that more and more money (credit growth) will be required to keep them going. This is not to say that individual asset markets cannot deflate despite expansionary monetary policies.
The demise of Amaranth Advisors, with US$9.5 billion under management, is a good example. After having gained almost 30% through August, it lost more than 50% of its net asset value in two weeks, as natural gas prices declined — and this must be stressed — only modestly. As can be seen from Figure 10, natural gas prices tumbled earlier this year and then traded at around US$6 per MMBtu until late August. Then, on only a 12% drop in prices, Amaranth Advisors incurred its colossal loss!
This raises some interesting questions. If a trader could lose more than 50% of a firm’s capital on a 12% price move, one has to wonder how large losses will be in some markets once high volatility returns to the asset markets! On a sharp rise in prices, some short sellers could be hurt badly; while on a sharp fall, some holders of leveraged long positions could be buried. My friend Bill King described recently the problem of excess liquidity depressing returns and forcing market participants who wish to achieve high returns to increase their leverage as follows:
A major problem with the flood of liquidity that continues to engulf the world is that returns collapse so increased leverage is necessary to generate acceptable (to investors) returns. This increases risk and lowers returns further, producing a self-reinforcing spiral of higher leverage and increased risks.
There is another important point that is lost or ignored by most people with regard to the massive liquidity that has been created by central banks over the past several years. While numerous pundits, analysts and investors herald the presence of the liquidity, they do not distinguish between credit and capital.
It’s one thing to be awash in liquidity generated from capital; it’s a completely different matter to be awash in credit-based liquidity. That’s why we are now seeing an increasing amount of hedge fund woes.
The underlying problem is a hedge-fund return crisis due to excess liquidity and diminishing returns.
That’s what felled LTCM — they wrecked spreads across almost every market because they had credit liquidity that most others did not. And their continued pursuit of applying increased leverage to capture decreasing returns fostered their implosion. That same self-destructive practice is occurring globally now, but on a scale and magnitude that is multiple of what LTCM practiced.
In May and June of this year we had a taste of increased volatility when most fund managers did badly. Now, volatility is almost back to its lows of the last few years, indicating extremely complacent sentiment among investors. And whereas overall volatility could remain low for a while, a return to higher volatility in future is almost a certainty.
But, while overall volatility remains low, as I indicated in last month’s report, we currently find widely diverging trends among different asset markets and economic sectors, which are likely to increase for the following reason. As Steven Cohen noted, there are thousands of investment managers — not just hedge fund managers but also fund managers who need to outperform their benchmark — competing for investment ideas and superior performance. Most fund managers have access to the same information, attend the same conferences, and deal with the same trading departments of large banks or brokers.
Therefore, the only way a fund manager can really outperform his peers is by increasingly taking large sector bets. Markets that lose momentum are sold, while sectors that turn up are purchased. This rotation among different countries, industrial sectors, commodities, and currencies leads then to enormously diverging performances for different asset classes and high volatility — not for the overall market — but for individual sectors, such as stocks, commodities, etc.
Take as an example Yahoo, which rose from only US$22 in March 2004 to US$25 at present. By any yardstick this is a very modest increase in Yahoo’s share price, but it was accompanied by several moves of more than 30% both up and down. So, while I conceptually agree with Steven Cohen’s comments that the “days of big returns are gone”, I equally feel that the diverging performances we are now seeing will lead to some large gains for well-positioned trading-oriented funds, while fund managers who fail to sell sectors and asset classes that enter a correction or bear market will lose out.
Now, I am aware that this observation sounds trivial, if not stupid. However, there are some important investment implications. In the 1982–2000 US bull market for stocks and bonds, investors who bought and held stocks and bonds, ideally with leverage, couldn’t fail to do well. The same can be said of the bull market for all asset classes from October 2002 to May of this year. So, during these periods, an investor who allocated his funds to, say, 100 different hedge fund managers (such as some funds of funds do) would have in general done well despite the high cost structure (2% management fee plus 20% performance fee).
But if we now move into trading markets as opposed to trending markets, as I believe is likely, new strategies will have to be adopted by investors. We have seen that in universal asset bull markets, such as we had between 2002 and recently, a fund of funds could allocate its money to managers in different asset classes and perform well. But if we move into the trading market, it is likely that out of 100 fund managers some will do exceedingly well while others will fail badly because they are positioned in the “wrong” asset class. The problem will then be that the investor will pay performance fees to the performing funds and won’t receive anything back from the poorly performing funds (in terms of performance fees).
As a result, the entire fee structure will begin to weight heavily on the performance of the fund of funds or of an investor’s portfolio that pursues a similar strategy of allocating money to different managers who charge a performance fee. I am fully aware of what the wealthy investors and fund of funds people will say. They will argue that they know how to pick the “right” managers among the 7,000 or so hedge funds and how to avoid the ones that are likely to fail.
But if we consider that over 80% of long fund managers don’t beat the indexes because they cannot identify sectors and stocks that perform better than the index, and also because of their fees (modest in comparison to hedge fund fees but nevertheless high enough to put them at a disadvantage compared to an index that has no fees), how likely is it that funds of funds will beat the indexes by having the ability to pick only the “good” hedge fund managers — especially given the fund of funds fee structure? Moreover, since some very prestigious names in the investment business had money with Amaranth, I suppose that picking the “right” manager is about as difficult as picking the “right” stock.
Now, I am not trying to criticize the concept of the fund of funds, or an investor who allocates money to a large number of different hedge funds. However, it may be worthwhile to consider whether a similar or higher performance (with less risk) could be achieved by allocating money simply into a variety of exchange-traded funds (ETFs), based on some technical timing model — a strategy that would entail far lower fees.
There are two more points I wish to make about Steven Cohen’s view that “the days of big returns are gone”. This is now a consensus view among investors, but maybe some asset markets, such as the Nasdaq and the S&P, could surprise us first by a sharp rise, only to fall back later.
I have mentioned this because in an environment such as the current one of easy money, markets can increase, at least in nominal terms, rather steeply. (If money was tight, it would unlikely be that the US stock market is now close to a five-year high!) Now, under the assumption of a sharp stock market rise, it would surprise me if hedge funds as a group performed better than the indexes, because following the May/June market weakness most hedge funds have reduced their net long positions.
So, if the stock market were to surprise us on the upside, the hedge funds might be squeezed back into the market and forced — in order to perform — to increase their long positions. After that they would be equally as vulnerable as the ordinary ETF or individual stock investor should the market suddenly turn down.
Lastly, if indeed “the days of big returns are gone” for the hedge fund industry, as Steven Cohen suggests, an investor might consider going back to basics simply by buying a diversified basket of companies with a reasonable track record and solid management with, say, 30% of his assets and parking his remaining funds in Treasury bills, short-duration bonds, and gold.
With this strategy an investor would incur an opportunity cost should the stock market soar, because he would only have a 30% net long exposure. (However, his costs would be very low compared to a 2% management and 20% performance fee.) On the other hand, his risk exposure if the stock market fell would be limited compared to any fund manager or hedge fund, which would on extremely rare occasions have only a 30% net long exposure.
My friend Bennet Sedacca of Atlantic Advisors (www. atlanticadvisors.com) recently sent me a figure showing the annualized 16-year return for the Dow Jones Industrial Average, which I found very interesting. And while this figure doesn’t include dividends, the broad message is visible. (It is not adjusted for inflation, either.) Great buying opportunities occurred whenever the 16-year annualised returns were either below the mean, which was 6.6%, or ideally when it fell into negative territory, as was the case in 1932, between 1940 and 1945, and in 1982.
Conversely, when the 16-year annualised returns were around 11%, the market was a better sale than a buy from a long-term perspective. As can be seen from Figure 13, while the 16-year returns have come down significantly since 2000, they are still above 9% — which is significantly above the mean of 6.6%. Now, giving the benefit of the doubt to the optimists by assuming that the annualised 16-year returns will remain between 9% and 10% per annum for the next few years, an investor with a net long exposure of only 30% would, as indicated above, incur an opportunity cost.
However, based on Figure 13, the likelihood that the annualised 16-year returns will move towards the mean of 6.6% — and eventually towards zero — is very high. Therefore, the 30% exposure in equities could be increased once the returns drop below the mean or towards zero, as the probability of returning from below the mean to the mean then increases significantly.
There is, of course, also the possibility that the 16-year annualised returns will surprise Steven Cohen and myself and return, through a strong rise in the stock market, to the highs we saw in 2000, when they reached 16% per annum. However, we shall now analyse under what kind of conditions such high returns could be achieved.
THE UNLIKELY GOLDILOCKS OUTLOOK!
There is a school of thought that argues that corporate profits will continue to expand for the next few years at around 12% per annum. At the same time, inflation will come down because of weakness in commodities and continuous import price deflation, thus bringing about lower interest rates and a P/E expansion. Furthermore, any weakness in housing would be offset by higher wage gains, strong capital spending, and a consumption boost because of lower energy prices. We should also consider the recent decline in interest rates, which is likely to support the housing market and consumption. It is true that interest rates are higher than they were two years ago, but higher interest income by households could at least partially offset higher mortgage rates. In other words, we have the perfect Goldilocks scenario!
Having been in the investment business for 35 years, I have learned to respect any view and never to dismiss any forecast as impossible. However, if we look at the current economic and financial fundamentals, a return to 16% annualised returns for several years would seem to be most unlikely. For one, it is far from certain that commodity prices will decline by much more, and even if they declined that inflation would decelerate and not accelerate. Inflation as measured by the Consumer Price Index (CPI) has far more to do with money supply and credit growth than with commodity prices. As an example, commodity prices declined in the 1980s, but because of expansionary monetary and fiscal policies many Latin American countries experienced hyperinflation. Also, we could argue that if declining oil prices act like a tax cut for consumers, the global economy, which is already in the midst of a synchronised boom, could overheat and actually lead to an increase in inflationary pressures — especially given that interest rates would appear to be artificially low, a condition that in the long run is inflationary.
Jim Grant of the Interest Rate Observer recently published a figure compiled by the Bank for International Settlements, which clearly shows that interest rates remain below the “natural” rate. (According to the BIS, the “natural rate” means the average, inflation-adjusted, long rate adjusted for the output gap.) I might add that in the US, bond yields also remain below nominal GDP growth. The last time this was the case, in the 1960s and 1970s, it led to accelerating inflation. It would also be wrong to think that weakness in housing will automatically lead to lower inflation.
Deprived of their self-replenishing automatic teller house machine, households may press for higher wages. In this respect, it is interesting to note that according to Doug Noland, “total non-farm compensation per hour was up 7.7% y-o-y during the second quarter of 2006, a notable increase compared to Q1 2006’s 6.4%, Q4 2005’s 4.1%, Q3 2005’s 4.8%, Q2 2005’s 4.0%, Q1 2005’s 4.5%, Q4 2004’s 3.8%, and Q3 2004’s 3.2%”.
I am aware of the notion that globalisation keeps wages down, but since most jobs cannot be outsourced, wage inflation could still accelerate or remain stubbornly high. According to Business Week, the US health-care sector (mostly care for the elderly) and housing (including homebuilders, real estate agents, mortgage brokers, etc) added 1.7 million and 900,000 jobs, respectively, since 2001, while jobs in the rest of the private sector contracted. I am not suggesting that it is a certainty that wages increases will continue to accelerate (see also below), but if they did they would begin to have a negative impact on corporate profits, which tend to expand strongly when wages as a share of GDP and of corporate revenues decrease (see Figure 16).
Therefore, the optimists have to make up their minds! Either household incomes will continue to increase and offset weakness in the housing market but at the same time contain corporate profit growth (see Figure 16), or household incomes will decelerate and cannot offset weakness in the housing industry. The latter outcome would then bring about a significant economic slowdown, which would obviously not be particularly favourable for corporate profits.
Concerning the miracle corporate profits of US corporations, I am grateful to Gerard Minack, one of the most insightful economists I know, for having produced two figures that explain all we need to know about the quality of US corporate profits. Figure 17 shows how manufacturing profits as a percentage of the economy, despite their recent recovery, have trended down since the 1960s, while all other sectors have increased their profit share.
Now, optimists will argue that this figure is irrelevant, since the economy has become a service economy and manufacturing, like agriculture over the last 100 years, is becoming irrelevant. I do have sympathy with this view, except to say that manufacturing is relevant for the international competitive position of a country as large as the US. But even more interesting is Figure 18, which shows the composition of the non-manufacturing profit share of GDP.
The profit share of corporations outside of manufacturing and the finance sector has remained fairly constant since the 1960s, although it rose recently, but the share of the financial sector has soared (see Figure 18). I might add that the share of “Financials” would be far higher if profits from the financial transactions of manufacturing and multinationals that run treasury departments, which resemble hedge funds, were included. Also, the reason “Other profits” have edged up is that “Overseas profits” have been a driver of corporate profit gains in recent years.
All this is irrelevant to the Goldilocks crowd. To them, all that matters are total profits. However, I was recently alerted to a mistake I made when I compared capital spending to corporate profits and indicated that corporate profits drive capital spending. Sean Corrigan took me rightly to task by making the case that, in the long run, it is obviously capital spending that drives corporate profits. A company or a country that has no net new investments (including R&D) will eventually lose out to its competitors and eventually go out of business.
US import price deflation may also be a thing of the past. In the Goldilocks scenario, US interest rates are supposed to decline (leading to the expected P/E expansion). This, however, could weaken the US dollar and lift import prices further. Some of my friends in the know think that the Chinese RMB should appreciate by about 20% or more against the US dollar over the next two years or so. (According to some studies, the US dollar is about 40% overvalued against the RMB.) A strengthening Chinese currency, combined with strong wage gains and higher input prices in China, would most likely lead to rising Chinese export prices and rising US import prices. This could add to inflationary pressures in the US. The Goldilocks scenario crowd thinks that the Chinese currency will weaken against the US dollar!
The Goldilocks scenario is also dependent on the housing market only slowing down and not collapsing. Several economists have downplayed the size and vulnerability of the “housing bubble”. But I have the impression that we are at an extreme — if not in home values, then certainly in mortgage borrowings! This doesn’t mean, however, that a collapse is imminent. Like a good wine, a perfect crisis takes time to age and mature. This was the case for the Japanese banking crisis in the 1990s and the Asian crisis of 1997/1998. So, housing may hold up for a while longer, as interest rate cuts are increasingly likely, and only collapse — at least in real terms — in a couple of years. But, if housing holds up, it is unlikely that inflation and interest rates will decline much.
As I was writing this report, Wal-Mart announced that it will cut prescription prices on 291 drugs in Florida pharmacies by as much as half to US$4. “Hurrah!” the optimists will exclaim. “See, we are in the midst of a deflationary boom, which will propel equity prices higher!” But what about corporate profits if prices decline? In any event, the stock of both CVS Corp (CVS) and Walgreen (WAG) both declined by more than 10% the same day, indicating that investors were concerned about these two companies’ future prospects given Wal-Mart’s increased competitive threat. After their drop, both stocks were no higher than a year ago!
What about higher interest income offsetting higher mortgage rates? The problem with this view is that the higher interest income isn’t received by the same people who have high mortgage and other debts. I am indebted to Chris Wood, the irreplaceable Asian strategist at CLSA, which shows very clearly the rising wealth inequity I have referred to in earlier reports.
As can be seen, the top 20% of US households’ share of total income rose from 43% in 1970 to over 50% at present, while the share of the bottom 20% accounted for just 3.4% of aggregate household income. (The bottom 20% are more likely than the top 20% to be clients of the subprime lending industry.) If the top 20% of US households accounted for more than 50% of aggregate income, then 80% of US households would account for less than 50% of household incomes.
October 13, 2006