Sunday, July 25, 2010

A Bearish Predisposition?

From systemic risk of capitalism, we move on to more current events. I had lunch today with Greg Gregoriou, a professor of Finance at SUNY (Plattsburgh) Greg has published many books and articles, and his most recent article with Razvan Pascalau on the optimal number managers in funds of hedge funds has garnered much attention.

Interestingly, while some major funds of hedge funds lost out in the crisis, assets from global pensions remain stable. Moreover, hedge funds are much more focused on meeting institutional demands:

Pension funds globally typically allocated less than 5 per cent of their portfolio to hedge funds or funds of hedge funds (while targeting an allocation of 6-10 per cent), and while this share has increased over the last few years, many expect it to double or triple in the years ahead.

In the US, private sector pension funds look to allocate on average up to 10 per cent of assets to hedge funds, a little ahead of America’s public sector pensions, which target about 8 per cent. In the UK, some of the biggest schemes allocate up to 15 per cent of their portfolio to hedge funds. In continental Europe, the take-up of hedge funds by pensions has been more mixed, but pension funds in some markets, such as the Netherlands, have embraced hedge funds and other alternative investment strategies.

The global economic crisis provided only a temporary interruption in the growth of institutional investments. Investors pulled about $300bn (£197bn, €232bn) out of hedge funds between October 2008 and June 2009, but inflows returned to healthy levels in the second half of 2009. Recent surveys by Credit Suisse and Deutsche Bank suggest the industry may attract $200bn-$300bn of new capital this year. It appears a large part of redemptions that followed the 2008 crunch were from wealthy individuals rather than institutions, and that institutions continued contributing new capital throughout most of 2009.

As part of their own growth and maturation, and in response to greater institutional investor demand, hedge fund managers and firms of all sizes have become more institutionalised in terms of their internal systems, structures and general operational infrastructure. This can be seen in the use of risk management practices and systems, compliance procedures, performance and risk reporting, governance structures and overall operational sophistication.

Institutional investors demand the highest quality operational and risk management systems from the funds they invest in, and to attract and in response to investor feedback, hedge fund managers have developed sophisticated asset management and trading infrastructures.

These demands have required significant investments by managers in systems, technology and people. However, the benefits to investors and managers outweigh costs. The emphasis by investors and policymakers on transparency and systemic risk analysis will serve to reinforce and continue this infrastructure build.

The institutionalisation of the hedge fund industry has been a developing theme for the past 10 plus years and is likely to continue. It will also assist them to meet new regulatory demands.
FINalternatives reports that three of New York City’s five public pension funds are mulling their first allocations to hedge funds. So why the fixation on hedge funds? Part of it is gaining access to top investment managers who deliver alpha no matter what market cycle we are in, part of it has to do with the focus on risk management and managing liquidity risk, and part of it is the whole fixation with alternatives (hedge funds, private equity, real estate, commodities and infrastructure).

Here in Canada, sophisticated public pension funds are scaling back, being a lot more selective with the hedge funds they partner up with, preferring to manage assets internally.

But whether or not you farm out assets to hedge funds or manage assets internally, you still need to understand the cycle we're in. Greg told me he sees a repeat of the 1966-82 period where the Dow basically traded sideways. He told me some of his colleagues at SUNY are working a little longer before retiring, but they plan on "pulling their money out of the market once the Dow goes over 13,000 again".

In his article, A Bearish Predisposition, MarketWatch's Mark Hulbert notes that advisers are not betting on a rally:

The stock market had its best day in over two weeks on Thursday, with the Dow gaining more than 200 points.

And yet, the short-term stock market timers I monitor didn't budge: They finished the day just as bearish as they were before the session began.

But, when I recently went back and reviewed what the advisers were saying then, one of their arguments stood out as providing a good illustration of how excessive pessimism got the better of some of those advisers.

The particular argument involved drawing a parallel between the rally that began at the Mar. 2009 stock market low with the rally that began in late 1929, following that year's stock market crash, and which lasted until the following April. A number of the advisers I monitor drew charts superimposing the post-Mar. 2009 performance of the Dow Jones Industrial Average with the index's rally 80 years previously -- and, upon noticing a superficial resemblance, predicted that the market would continue to follow the same script this time around.

That was a very scary prospect, of course, since the Dow dropped some 85% from its Apr. 1930 high to its Jul. 1932 low.

Have those advisers' worries come to pass? Not so far, at least. Almost immediately after they began drawing the ominous parallels, it became clear that the stock market was following an entirely different path. In fact, the market today is about twice as high as it would have been had it followed the script that so worried advisers last fall.

These advisers' response? They just quietly stopped mentioning the alleged parallels, focusing instead on some new found reason for concern.

In any case, it should have been clear to everyone that drawing parallels in this way is shoddy analysis. With over 100 years of daily data available for the Dow, as well as countless more years of stock market performance in other countries, one can fairly easily find any of a number of past instances that appear to bear an "uncanny" resemblance to the market's recent performance. And, yet, hardly ever is it the case that the market behaved in exactly the same way following each of those prior instances.

Of course, the advisers rarely acknowledge that history doesn't speak with one voice on a particular issue. Instead, they too often choose to highlight just one of the historical parallels.

Their behavior reminds of a famous remark attributed to Adlai Stevenson, the Democratic Party's candidate for President in the 1952 and 1956 elections: He was fond of mocking opponents by saying "Here's the conclusion on which I will base my facts."

And it's bullish from a contrarian perspective when the conclusion on which advisers are basing their facts is that the market is going to decline.

But the bears keep on growling, reminding us that systemic, structural problems aren't going away anytime soon. Bob Chapman of the International Forecaster notes this in his latest comment, Talk of a Recovery Hides Collapse:
Talk today centers around a stillborn recovery that never quite held on long enough to materialize. Five quarters of 3% to 3-1/2% growth traded for $2.5 trillion. Money and credit was thrown at the system again, and again it didn’t work. Keynesianism at its finest.

The housing purchase subsidies are gone, and real estate sales and prices are again falling. Even with interest rates near 4-1/2% for a 30-year fixed rate mortgage there are few takers in the hottest sales period of the year. There are four million houses in inventory for sale or 1-1/2 years supply. That figure could be 5 to 6 million by yearend, as builders’ build 545,000 more unneeded homes. More than 25% of mortgages are in negative equity. Excess mortgage debt is $4 trillion and headed much higher. Government is so desperate that they have begun to take punitive action against those whose homes are under water, but they can still make the payments, but are bailing out. What a disincentive for anyone to buy a house. Will debtors prison be far behind?

There certainly have been strategic defaults, but not as many as government would have you believe. Twenty-five percent of all borrowers are stuck with negative equity, which we expect will worsen. That could mean a wealth loss of some $4 trillion. Obviously, homeowners are hoping for higher prices. If that does not happen you can expect more walk-away foreclosures. There are already four million homes for sale and many more could be on the way. Plus, more than 500,000 more new homes are being added to saleable inventory annually. Next year will be another bad year for builders. Some will fail and others will merge. Government is having ongoing meetings with three major builders in an effort to nationalize the industry, as they will do with banking. Government is doing the worst thing possible. It reminds us of Sovietization. The only thing government has going for it is that underwater homeowners usually do not default until they are down 62% from equity, but that could change. Interest rates at 4-5/8% for a 30-year fixed rate mortgage should keep them in their homes for now, but if interest rates rise that plus could become a negative. That leads us to believe that interest rates will stay that way for a long time. As a result the Fed must keep interest rates at zero for a long time to have millions of mortgages kept from falling into foreclosure.

At $15.3 trillion the world’s holdings of US dollar denominated assets in ten years rose from 60% of GDP to 108%. This in part has been caused by a never-ending current account deficit. This factor alone makes one wonder how the US dollar can be a strong international reserve currency.

In just six years from 2001 to 2006, mortgage debt grew to $14.5 trillion - a credit expansion unheard of in history. In the past almost two years government borrowings have grown 49% just slightly more than the 45% in 1934-35. The Keynesian game is the same, it is just the time frame is different.

Over a 20-year time frame total US credit rose from $13 to $52 trillion, or to 370% of GDP. A good part of these credit excesses have been exported to the rest of the world and they are increasing exponentially; almost 160% just in the last six years, or to $8.5 trillion.

The deliberate move to expose Greece’s problems, which those in government and finance had been aware of for years, backfired and exposed all the problems in Europe in the process. The impact of Greece, and the elucidation of the depth of problems in Portugal, Ireland, Italy and Spain curtailed the so-called global recovery and exposed extraordinary weakness in the euro zone throughout the EU and Eastern Europe. That in turn will ultimately cause problems for the US dollar and the pound. There is now no question that the dollar rally is over and the question is when will the dollar retest the 74 area on the USDX? The leverage in banking is still 40 times deposits and we see no way to easily reduce that. We believe dollar reflation will have to be the answer for the Fed.

The financial terrorists that inhibit our banking system and Wall Street still remain confident that inflation caused by quantitative easing won’t show up for years, if ever. What else can the Fed and ECB do except use stimulus? The sovereign debt contagion in 20 major countries and as many creditor countries, is not going to go away anytime soon. These are systemic, structural problems. We certainly do not see the likelihood of the dollar proving any safe harbor. Those who have flocked to the perceived safety of the dollar are going to be very unhappy with the results.

Many countries are enmeshed in major debt and in the case of the US the debt is colossal. It is hard for markets to appreciate this in Europe, the UK and US. The problems of the credit crisis are not over and there won’t be a recovery, unless the Fed injects $5 trillion into the economy. That will keep the economy going sideways for two years as inflation rises. Small and medium sized business cannot get loans, so they cannot expand and hire. About 23% of large corporations may expand and hire. Offshore US corporations have far too much excess capacity already. As you all know there are many speed bumps on the road ahead. You had better be prepared for them.

Switching gears again, we find very little coverage of the problems in Eastern Europe. Hungary is a good example. Financial exposure is Austria $37 billion, Germany $32 billion, Italy $25 billion, Belgium $17.2 billion and France $11 billion. This kind of exposure to the banking systems of these countries could be very painful. It will be interesting to see if national governments, or the ECB step in as they did in Greece, and manage the problems. The world should be paying attention because there are 20 major countries in the same dilemma.

The sovereign debt crisis is just getting underway as observed with foresight. There has been no containment and 56% of Hungarian real estate loans are in Swiss francs. The problem, which we have been citing for some time, could cause a domino effect across Europe and we wonder if the solvent nations and the ECB can handle the debt rescue. Our answer is no. The next shoe to drop could be in this region and surprise almost everyone.

Mr. Chapman isn't the only one waiting for "another shoe to drop". Some market watchers point to the recent weakness in the Economic Cycle Research Institute’s Weekly Leading Index (a.k.a. ECRI WLI, see chart above) as evidence that growth rate and stocks will continue to plunge.

But others correctly point out that the ECRI WLI is pointing to a slowdown, not recession:
The Economic Cycle Research Institute's Weekly Leading Index has been on a downward trend since late April and has now hit a 49-week low, but does that mean a recession is close? According to Globe and Mail, some bears think so:

[The WLI’s] annualized growth rate of negative 9.8 per cent is perilously close to a 10 per cent decline, which the pessimists note has always been accompanied by a recession.

The Wall Street Journal last week quoted a British economist as saying the WLI is “very sensitive to financial indicators … leaving it vulnerable to feedback loops from the markets.”

Managing director of ECRI Lakshman Achuthan, however, is hesitant to follow the WLI blindly; he believes that predictions must be based on more complicated indicators:

He notes, it’s not a simple positive-to-negative swing that forecasts a recession, making the BMO analysis oversimplified, he says. ECRI is looking for “pronounced, pervasive and persistent” changes in the WLI.

And while David Rosenberg thinks a double-dip is imminent, Don Hays, founder of Hays Advisory Group, says a double dip is off the table and that the market will rally into the November elections.

My own feeling is that the liquidity tsunami has not crested and will push risk assets higher. Now that European bank stress tests are over, expect them to join the party on Wall Street. I also expect banks will start slowly lending again as employment growth finally shows some sustained improvements.

Finally, keep an eye on some shipping companies that will be reporting this week (for example, Dryships: DRYS). Any rally in shares of companies that are heavily leveraged to the global economic recovery signals that risk appetite is back. In fact, last week's one day bounce of Goldman Sachs and Amazon shares on the day they reported disappointing earnings may be an ominous sign of things to come. All those hedge funds desperately trying to find the next big bubble -- and they aren't alone. Stay tuned, we might not need QE 2.0 after all.

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