Harry Newton's In Search of The Perfect Investment
EST, Wednesday, November 5, 2008: Investors are deserting
hedge funds in droves. Some hedge funds are closing. Some hedge funds are suspending
redemptions. Most are simply dumping their stocks to pay off their itchy investors
and, for many, to pay off the banks which lent them money.
is no question that worldwide stockmarkets will be under huge selling pressure
between now and the end of the year. That -- and our lousy, worsening economy
-- are why I am not calling for a wholesale re-entry, despite the nice markets
of the last several days.
I recently asked
my friend, a senior editor at the Economist, why his magazine was doing so well
and other business magazines, e.g. BusinessWeek and Fortune, were doing so awfully.
He said the Economist's secret was simple: they believed that to discuss business
you had to discuss politics. His competitors believed they were distinct, separate
animals. Look at Zimbabwe for the idiocy of that "logic." Look at
the damage wrought by the Bush administration of the past eight years. And the
next eight years? Major slogging. Hard times. But ultimately major recovery.
I'm very optimistic this morning. It's nice to have a new president with fresh,
Exhibit 2: From
come home to roost.
My big worry
at the moment is what is happening to (some) hedge funds. Clearly, 2008 has
been to hedge fund investors what 1992 was to Queen Elizabeth II Annus
Horribilis (see chart 1).
Chart 1: Selected
hedge fund strategies (YTD performance)
did a study recently, showing that the 30 biggest US equity holdings amongst
US hedge funds were amongst the poorest performers in the S&P500. In other
words, it is likely that much of the recent sell-off in equity markets around
the world can be traced back to hedge fund liquidations.
There is no
question that hedge funds are downsizing at present. The problem is to obtain
precise data on the phenomenon. If we estimate that the global hedge fund
industry controls about $2 trillion of capital, and we assume that 15-20%
is going to be pulled out between now and year-end (which is not far from
the truth according to our sources), $3-400 billion must be returned to investors
between now and 31st December.
That is not the whole story though. The average hedge fund uses leverage,
to the tune of about 1.4 times (see chart 2). This is down significantly from
a year ago, but it still means that hedge funds need to liquidate investments
of at least $500-550 billion in order to meet current redemption requests.
And the real number is probably higher because some of the worst performing
strategies this year are the ones using the most leverage. The real number
is therefore more likely $6-800 billion, and that is a big enough sum of money
to put downward pressure on the markets.
Add to this
the fact that some hedge funds (mostly the bigger ones) have been selling
credit default swaps (CDSs). A CDS is an insurance against corporate default.
The buyer of a CDS supposedly makes money if the underlying credit blows up.
I say supposedly because the payment is a function of the sellers
ability to pay up. That was why Morgan Stanley had to be saved at all cost.
MS has been, and continues to be, one of the largest players in the CDS market.
Chart 2: Average
hedge fund leverage
There is no
way we can establish precisely how many CDSs hedge funds have on their books,
but please consider the following: The CDS market is a $50 trillion market
(give or take). Before they blew up, AIG were one of the biggest sellers of
CDSs with approximately $500 billion on their books. They ran into problems
(partly) because they were heavily exposed to the financial services industry
which is already in recession.
the early stages
The rest of the economy, however, is not yet in recession or rather,
we do not have the statistics to prove it. Corporate defaults are still low,
both here and in the US. But corporate defaults will go up as they always
do in recessions. If AIG, one of the largest and most sophisticated financial
institutions could get themselves into trouble with barely a 1% share of the
global CDS market, what will happen to the sellers of the remaining 99%?
this risk? Is it hedged or not? Is it even possible to hedge the risk, knowing
that your counterparty might not be able to pay up? What we do know is that
only the larger hedge funds have participated in the practise of selling CDSs.
Right now it feels very good not to be invested in those types of hedge funds
(as you may be aware, our focus is on alternative investment strategies away
from mainstream hedge funds). I also suspect that the extreme volatility in
recent weeks is somehow related to this phenomenon. Investor redemptions are
not the whole story.
I pointed out several months ago that the worlds stock markets would
present several false dawns before we could finally declare victory
against the bear market. Last weeks more upbeat tone was one such false
dawn, in my opinion. There are three reasons for that:
have not yet fully capitulated, and that is a necessary condition for markets
to turn around. It is best illustrated by a survey conducted by BCA Research
at the end of their two-day investment conference held in New York on 20-21st
October. Only five or six of the more than 250 people in the room expected
the stock market to be lower a year from now. Not consistent with capitulation!
Having said that, it is perfectly normal to experience powerful rallies in
the midst of a major bear market. The sharpest rallies in history have actually
been bear market rallies.
has a long way to run yet, not so much in the hedge fund community where I
suspect that much of the damage will be behind us once we pass the next major
redemption hurdle on 31st December, but in society more broadly. Governments,
banks, (some but not all) companies and, most importantly, the majority of
households are more leveraged than good is. I have borrowed Chart 3 below
from BCA Research, and it shows total US bank loans as a percentage of US
GDP. Unfortunately, the picture would be much the same for many of the European
countries. We are now facing a major de-leveraging cycle and it will suppress
economic growth and put a lid on the stock market for years to come.
Chart 3: Major
deleveraging cycle ahead
I fully agree that the worst of the financial crisis might now be behind us,
bear in mind that we have not yet seen the full effect of the economic crisis.
We are only in the first or second innings of this recession, and the emerging
market story has the potential to wreak further havoc. So do credit default
swaps - or something else. Recessions are by nature quite unpredictable. There
is one thing I am sure about, though. Just as for New Years Eve, the
more extravagant the party, the bigger the hangover. Prepare for this one
to linger for a while yet.
Murdoch thinks Harry Newton (i.e. me) is an idiot. I have received
a second mailed invoice from the Wall Street Journal for $299 for a one year
Yet I can go to
the Journal's web site and, guess what? I can get the same one-year subscription
for $103 (click here) Do
I look like a total idiot?
There's a lesson
here. Print media (like magazines and newspapers) are so desperate for money,
they're doing desperate things -- like billing you a year in advance, like charging
you nonsense high prices (like the Journal).
I put the Journal
on a month "vacation hold." I've been without the paper version for
the last two weeks. I have survived.
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
concerns and experiences. That way we can all learn together. My email address
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