RSSSix of the Best Questions for Challenging Markets
By Tim Price | September 04, 2008 | 10:36 AM | 2 Comments
"It's no longer a question of staying healthy. It's a question of finding a sickness you like."
- Jackie Mason.
Finding the right answers, so the saying goes, is easy; it's asking the right questions that's difficult. Mired in the midst of perhaps the most difficult-to-interpret markets for a generation, here are some of ours.
1. Isn't the market's myopic focus on the oil price more than a little simplistic ?
A: To the extent that the media (and the equity markets) are largely lazily associating lower oil prices with ‘good news', the singular focus on the price of oil is understandable but probably naive. Fundamentals first: on the basis that softer oil prices point to reduced demand, weaker economic growth is hardly a supportive backdrop for the stock market. Incipient movement toward synchronised recession is a more positive story for inflation and therefore for bonds. But what if oil is really just one of those monstrously crowded trades wherein momentum-chasing speculative capital drives the price up sufficiently beyond fair value / the marginal cost of production, until further gains are unsustainable, and then drives it straight back down again ? The viciousness of these oscillations around fair value in the tradeable energy sector is evidently sufficiently extreme to cause big hedge funds like the mis-spelt and obviously mis-managed Ospraie to blow up. But what difference does it make over the long term if the oil price gets kicked about by short term speculators within the context of a secular bull market and the effective evaporation of easily accessible oil ?
2. Are we entering a world of competitive currency devaluation ?
A: This has to be one of the biggest risks facing the world economy over the next few years - a return to ‘beggar thy neighbour' trade policy travelling in the guise of managed currency depreciation. The day-to-day headlines get grabbed by the relative valuation of US dollars to Euros and Pounds Sterling. (Or for UK investors, the continued depreciation of Pounds Sterling relative to just about everything.) But what if we were really living in a world where investors were starting to tire of the continued manipulation of foreign exchange rates and official inflation data ? In such a world, the arbitrary relationship between different fiat currencies backed by comparably unsustainable fiscal policies would be somewhat academic - a race to the bottom akin to following the relative performance of sickly gnats versus wounded fleas. To put this another way, how much of its purchasing power did the US dollar lose during the 20th century - a period during which it became the dominant global reserve currency ? Answer: over 98%.
3. Has the hedge fund market peaked ?
A: This perennial old chestnut gets wheeled out pretty much every time a large hedge fund blows up, or whenever the hedge fund industry hits something of a speed bump in performance. The CS / Tremont Hedge Fund Index currently shows year-to-date returns of minus 2.1%. Not exactly an absolute return, but before long-only stockbrokers start crowing, a good deal better than they will have done, both on a relative and absolute basis. There are legitimate reasons, however, to believe that the hedge fund industry is facing its most significant growth challenge yet. In two words, systemic deleveraging. In a key interview with Bloomberg's Tom Keene, David Goldman of Asteri Capital made the following observations. When asked what was different about the hedge fund business now versus 10 years ago (at around the time of the collapse of Long Term (sic) Capital Management), Mr. Goldman commented:
"It's much bigger and much more vulnerable.. With everyone forced to take the same trade, the volatility intra-month is so great to those investors who are committed to a month-by-month Sharpe Ratio, low volatility strategy [that they] will be forced to redeem, and you will get wild swings and illiquidity and inability to liquidate positions.
"So I think we are going to have a serial catastrophe of hedge funds, particularly the kind of funds that thought it was a great idea to buy loans at $0.90 on the dollar, and won't be able to sell them at $0.80 later in the year.. If you have to grind out returns month by month.. you end up creating more volatility because you have to - you are all in the same trade at the same time. And every turn is like a stampede out of the crowded theatre."
In fact it could be worse than that - as Ospraie and Peloton have already discovered this year. I particularly like a simile I heard during a recent investment seminar in London. Selling distressed assets into an illiquid and stressed market is worse than a stampede out of a crowded theatre. It is like only being able to escape a crowded theatre - that also happens to be on fire - by persuading someone on the outside of the building to swap positions with you.
None of which means the end of hedge funds - but it does point to a particularly inglorious future for also-ran, me-too managers slavishly leveraged and following the herd as opposed to being ahead of it. As Mr. Goldman suggests,
"find managers whose convictions you believe in, who are willing to swing for the fences, and [who] will insist on taking your money for a period of time and basically have the courage to do it or keep it in Treasury bills."
Or as hedge fund investor Jonathan Spring puts it, alpha is not (just)
"diversification, contrarianism, high conviction themes, value-added stock picking, buying the secular low, or ephemeral "manager quality" (usually proxied by pedigree). It is recognizing under-valued and over-valued risks and then doing the things that others won't or can't do to profit by them. [Emphasis added.] The reason that so many investors are flummoxed is that their ingrained (and Wall Street-reinforced) convictions are to over-value recent returns and under-value optimal portfolio constraints such as liquidity. Investors have been trained to focus on the wrong things and, as a result, end up relying on luck and the ever-upward world economy to float their boat.. everyone has become a momentum-trader, following someone else's coat tails instead of trying to think for themselves. Is it any wonder that people are lost now that so many leaders have fallen ?"
As a side note, sceptics of the hedge fund proposition typically draw attention to the "high" fees levied by managers. 2% and 20% of performance looks rich by comparison to, say, 1.5% charged by an index-tracking manager destined to underperform his benchmark after the cost of that 1.5% plus dealing slippage and other sundry costs. But it all comes down to the net returns. The very best managers can charge what they like and the world will still beat a path to their door. And hedge fund charges stack up quite well against the cost of owning the equity of investment banks, for example, where the typical ratio of compensation to revenues runs at around 50%. Paying 50% in management fees - irrespective of your returns as a shareholder - does look a little rich.
4. Is there value in bank stocks ?
A: In a general sense, there is - if you like running the risk of being wiped out during a messy and probably protracted nationalisation process. There isn't, if you believe that most commercial let alone investment banks are technically insolvent and will only be allowed to perpetuate themselves by means of regulatory legerdemain allowing a fudged return to book cost accounting. There are obviously big short term returns to be made for fast money investors. But see the references to crowded trades, volatility and distressed selling (and potentially burning alive in a crowded theatre), above.
5. Do investors place too much store in fundamentals relative to technicals ?
A: Almost certainly. Investors tend to treat fundamentals as superior, even though they are essentially subjective. There is still widespread suspicion of ‘the charts', notwithstanding the fact that the only indisputable and uncontradictable statement as to the value, prospects and popularity of any financial instrument is the evolution of its price history. Note, for example, the fact that as far as the share price was concerned, ‘the market' knew that something was wrong with Northern Rock a long time before either the regulators or even its own board did.
6. So where are the safe havens ?
A: "Safety" will, to an extent, be in the eye of the beholder. Very few asset classes have managed to deliver positive nominal returns this year. But as we suggested last week, it would be dangerous to make too many deductions and extrapolations from a relatively short term period, particularly one in which financial incompetence and significant deleverage have been so universal. So we still believe in asset class diversification across equities, bonds (and not least cash), real assets, private equity and (funds of) hedge funds. In selecting individual securities, the focus should be on absolute quality and scarcity - little or no indebtedness, and plenty of ‘franchise value'. In selecting third party managers, the focus should be on individuals who can easily articulate their edge, who have a recognised history of outperformance, ideally on an absolute rather than a relative basis, who have a meaningful proportion of their overall net worth invested in their funds, and who value capital preservation over growth at any cost. We still see no reason to be attempting to bottom-fish amongst financials, and we continue to believe that gold at around $800 offers superb potential for significant capital gains during an environment of acute financial restructuring and the possibility if not probability of an ultimately inflationary banking system bailout. But that may have to be a medium term story. In the shorter term, inflationary pressures are abating and economic growth internationally, along with consumer confidence, is melting down. That is a very positive near term environment for quality (i.e. AAA) government bonds. But inflation-protected debt still offers the better long term hedge. In short, if you can't find something you can sleep at night owning, or you lack conviction over the longer term, there is no dishonour in holding cash.
Visit Tim's blog: thepriceofeverything
| 
|
Comments (2) | Related Topics » The Market | Education | Economy | Fundamentals
|
|
