The ‘Long’ Summer

For anyone who has read my previous articles, they will no doubt have sensed a strong scent of bear (which is probably better than a strong smell of bull!). Having warned readers in the spring edition about too much gearing in hedge funds it gives me no great satisfaction to report that those concerns came to fruition within a matter of days after publication. The hedge fund world has its share of heroes as well as horrors and it is often difficult to determine which is which until a downturn appears. When interest rates are low, it does not take a genius to borrow several times the value of a fund’s assets and produce double digit returns (even from government bonds) while slicing off a healthy chunk in ‘performance fees’. For the majority of funds who climbed further up the risk ladder there were three combined factors that greatly helped them over the last few years. First, borrowing costs were exceptionally low which allowed funds to gear up and magnify returns, second, the Dollar weakened which favoured more aggressive overseas investment and third, high risk bond prices rose significantly as investors hunted for yield.

Just as three factors came together to help these funds, so they have joined in unison to hurt them. US interest rates have risen, thereby pushing up the cost of borrowing, which in turn has damaged many hedge fund performance numbers. As rates have gone up, the attractiveness of gearing has diminished. Also, when borrowing in Dollars it means that you are effectively ‘short’ of the currency. If the latter strengthens, you then start to make a loss on foreign investments. You must therefore buy back Dollars to reduce the gearing. A ‘short squeeze’ then follows which drives the currency higher still. At the same time, many funds rushed for the exits when the bonds of General Motors were downgraded yet again. Other high yield bonds were also ditched and the whole process created a self-fulfilling decline. It is rather like watching a horror film where the monster jumps out of the screen into a packed cinema audience who then rush out in the opposite direction; some are devoured by the beast itself while others are crushed underfoot by the stampede. One of the selling points of the funds is that they complement your portfolio by reducing the correlation of the different assets. However, because there are simply too many hedge funds and too few opportunities the selling of risky investments across the world meant that many asset classes started to correlate strongly. In other words they all fell together, although it has to be said that some fund losses have only been in the low single digits.

The purpose of this commentary is not to gloat but to point out that there could be a hidden and unexpected benefit for ‘long only’ investors following this episode. As any spin doctor or management consultant will tell you, every threat is an opportunity and for once I agree. The first benefit may come from an expansion in Price Earnings (P/E) ratios which is one factor that drove the markets higher in the late ‘90’s. Although major indices such as the Dow Jones Industrials are unchanged over 6 years, company earnings have since soared. P/E ratios in America are therefore at their lowest level in 8 years. In recent months, the combination of a strong Dollar and a weakening economy has helped to push down bond yields (or long term interest rates). Even if company earnings stabilise for the remainder of 2005, the fall in these long term interest rates should remove the downward pressure on share prices. Second, it appears that many hedge funds back away from the stock market in the months ahead as they lick their wounds and keep a low risk profile.

Although it is hard to prove, one suspects that part of the reason for flat stock markets is that they have been trapped on either side by hedge funds. Every trend on both the upside and downside has been stopped dead in its tracks by the sheer number of these players who operate on both sides of the market. To use an analogy, it reminds one of a pride of lions around a herd of antelope. When the number of these predators is limited then the two species work in harmony. The lions are well fed and help to keep the antelope herd healthy by picking off the weaklings. In the meantime, the herd still has the freedom to move around and graze unhindered. However, when there are too many lions, the herd is surrounded and cannot move. Over time the lions kill all the antelope and they in turn die off because their large numbers are not sustainable. This is very similar to stock markets where the aggressive financial predators are too great in number so the opportunities disappear and the market itself becomes range-bound and listless. Perhaps now that hedge funds have been badly hurt then the markets will be free to move higher, albeit for a few months, in what is usually the quiet summer period.

The great yields and equity valuations that are normally seen at the bottom of a market downturn have simply never materialised. This was due to the huge economic stimulus applied by America to stave off the combined effects of the burst Internet bubble and 9/11. I suspect that while the bear has been subdued, it is still very much alive and grumpy. Speaking of which, the word ‘berserk’ refers to the behaviour of rampaging Vikings who frequently wore bearskins to invoke the spirit of these ruthless animals. As the warm summer weather approaches, I for one will slip off the uncomfortable bearskin and swap it for the more comfortable but thick skin of the bull. Although it goes against the stock market adage of ‘sell in May and go away’ it appears that 2005 may be the exception. Nevertheless, the freezing winter of deflation is lurking in the background with the classic pre-cursor of all major downturns very much in evidence; namely, too much debt coupled with rising commodity prices. When autumn approaches we should use any stock market rally or Dollar strength as a selling opportunity. I am accumulating Gold bullion and Gold shares in the expectation that central banks will print money like confetti in a bid to stave off deflation. My one concern is that during the Great Depression the American government confiscated all physical gold holdings when they devalued the Dollar. This action prevented the wealthy from preserving their purchasing power. We must therefore hope that history does not repeat itself, although nothing should come as a surprise where government intervention is concerned.

Toby Birch
June 2005