Will The Real Smart Money Please Stand Up?
Peter Cohan of DailyFinance asks, Hedge Funds Bet on Inflation, Institutions Bet on Deflation. Who's Right?:
The smart money -- by which I mean hedge funds and institutional investors -- is placing its bets outside of the stock market. But the smart money isn't by any means in agreement about the direction of those bets: Hedge funds are doubling down on big inflation down the road by buying gold. But institutions are buying corporate bonds -- a wager on deflation, since bonds grow in value as prices and interest rates fall.
The only thing they do agree on is that neither group wants to invest in stocks. But should you follow them? And if so, which way?
Hedge fund honchos such as George Soros, Leon Cooperman, John Paulson and Erich Mindich are making big bets on gold because they see the specter of inflation ahead. Bloomberg reports that Mindich's $13 billion Eton Park Capital Management bought 6.58 million shares of SPDR Gold Shares (GLD) -- an exchange-traded fund that tracks the price of bullion. In that gold trade he joins Paulson -- operator of a $31 billion fund -- who personally made $3.7 billion in 2007 betting on the subprime mortgage meltdown.
Meanwhile, institutional investors who are tired of getting beaten up by their clients -- who are themselves tired of paying big fees for weak performance -- are starting to creep out a little further on the risk-return frontier from buying U.S. Treasury bonds to scarfing down blue-chip corporate bonds. According to Fortune, 10-year notes for Johnson & Johnson (JNJ) yield 2.95%, a mere 0.43 percentage points more than comparable Treasurys.
Yet institutions are clamoring to buy them, and companies are happy to lock in the cheap capital. What strikes me as interesting is that institutions are willing to pour capital into those low-yielding bonds when J&J's stock sports a much higher 3.69% dividend yield (dividend/stock price). This suggests that institutions are still too scared to buy stocks.
Common Stocks: The Bottom of the Liquidation Hierarchy
These times are heaven on earth for those in the bond trade. As PIMCO honcho William Gross told me in February 2009 -- a few weeks before the S&P began its 49% rise from around 735 to its current 1,098 -- we're in an era where owning stocks is pointless. He made an interesting argument: With slow economic growth, it makes no sense to take the risk of being at the bottom of the so-called liquidation hierarchy.
When a company files for bankruptcy, its bank lenders get first dibs on the proceeds from selling the company's assets. If there's any cash left over, it goes to bondholders, then preferred stockholders, and last of all to the people who hold the company's common stock. Gross argued that investors are better off buying bonds because with a reasonable risk of bankruptcy, such investors will be better off than stockholders.
This is a great argument -- except for the fact that it has proven to be wrong recently. And the odds of companies going bankrupt seem to be diminishing. Corporate America is in a cash-hoarding mood, holding $1.84 trillion according to the Federal Reserve. And since these companies can now lock in extremely low long-term borrowing rates, their balance sheets have been buffed up even as their common equity is out of favor with investors.
Can They Both Be Right?
One thing seems to clear to me: The gold bugs and hedge funds betting on inflation and the institutions betting on deflation can't both be right at the same time. It's conceivable that the institutions could be correct in the short and medium term, while the gold bugs end up being right in the long term.
Let's face it -- those hedge fund guys are the smartest and richest in the investment universe. But all the statistical evidence I've seen says inflation is dead and is staying buried despite the 140% increase in the U.S. national debt since 2000 from $5 trillion to $12 trillion.
Maybe the hedge funds buying gold are momentum traders -- in that case they're buying because everyone else is buying, and they're betting that they'll be smart enough to get out before that buying turns to selling.