Thursday, June 26, 2008

The Mother of All Ursas?

Michael Metz, Chief Investment Strategist at Oppenheimer once remarked that "it's worse being a bear when you're right". Indeed, if you make money during a down market, don't tell your neighbors.

Big institutions have all sorts of ways to make money during bear markets including investing in hedge funds as well as developing internal absolute return strategies. Unfortunately, while hedge funds sound sexy, the reality is that most hedge funds are charging fees for disguised beta. Just like private equity funds, if you are not invested in the top hedge funds - and there aren't that many of them increasing their capacity to accept new capital - you are going to get creamed in these treacherous markets.

But there is another way for large and small investors to make money in down markets. Financial engineers have developed new products that anyone can buy and sell to make money when stocks dive. They are called Short and UltraShort Proshares ETFs and you can read all about them here. I have included an image of the UltraShort Proshares I currently track above (click image to enlarge).

You will notice volume was heavy on the UltraShort Financials (SKF) and UltraShort QQQ (QID) today. These ETFs are very volatile and I would not recommend you buy and hold them for long, but when markets puke they are engineered to rise by twice as much as the percentage loss of the underlying stock index. The one I think has more room to run-up is the UltraShort Real Estate Proshares (SRS). Many US REITs are priced for perfection and they face serious headwinds, including:

  • weak securitization market and capital constrained banks
  • office space rising
  • consumers' pricing power getting squeezed by too much debt, rising unemployment and rising inflation
This brings me to why I believe we are going to experience the Mother of all bear markets. Today was a good day to close my computer early and head off to lunch with a senior pension fund manager who I used to work with. I have tremendous respect for this individual because he is a thinker who reads a lot and is not afraid to question conventional wisdom. He has zero tolerance for petty politics or Monday morning quarterbacks.

Our conversation was extremely interesting. He is bearish these days so we had lots to chat about. He remarked that the BKX index which tracks financials hit an eleven year low. We both agreed that bottoms can only be called after the fact with the benefit of hindsight (always remember Keynes' famous quote that "markets can stay irrational longer than you can stay solvent"). This credit crisis is far from over so despite the selloff, financials might be in the early stages of a long structural bear market.

We then discussed oil prices and the instability of the global financial system. He remarked that in the past, the Fed had a lot more power than it now does to influence financial markets. Global linkages of capital markets spurred by huge pension, mutual and hedge funds have significantly changed the structure of the global financial system. "The world is a much more dangerous place and I fear that the next recession will be very painful."

I completely agree with his assessment. Very few pension funds have contingency plans for global systemic risk. Asset classes are more correlated than ever before and pension fund managers need to start thinking harder about downside risk to the total portfolio, not just individual asset classes. Diversification will not help you in this Ursa Major because the tech bubble subsided only to be replaced by a bigger real estate, private equity, hedge fund and commodity bubble. (I expect a lot more hedge fund blow-ups in the next 12 months, especially in strategies that trade illiquid credit securities.)

Pondering whether equities have entered the Great Crash territory, Jeremy Warner remarks the following in today's Independent:

"The key question for stock markets is whether the cycle is ending in an inflationary or a deflationary nemesis. Though much has been written and said about the possibility of a return to the stagflation of the 1970s, the bigger long-term threat to share prices would be the deflationary outcome. Experience from the 1930s and Japan from 1990 onwards shows that deflationary influences are profoundly more destructive of equity values than inflationary ones."

He goes on to write:

"Undoubtedly the developed world is in for a very difficult couple of years. Living standards will get squeezed, unemployment will rise and equity markets must logically suffer along with all other asset classes.

At the bottom of the last bear market five years ago, Edward Bonham Carter, chief executive of Jupiter Asset Management, said that it would take until 2010 for the stock market to return to its turn of the century peak. At the time, this seemed unduly pessimistic. If anything, it now looks on the optimistic side. But in the round it seems about right.

A similar period of sideways trading took place from the mid-1960s. In that case it was 17 years before the Dow broke free of the rut it was in. A prolonged period of adjustment, rather than an outright crash, still seems to me the most likely outcome."

I hope Mr. Warner is right but I fear that this will be the Mother of all Ursas and pension funds will suffer severe funding shortfalls as equities and interest rates plummet in a multi-year debt deflation spiral. If that turns out to be the case, pension funds will shun sexy alternative assets altogether and go back to investing in good old boring government bonds.

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