Tuesday, August 9, 2011

"End of the road for hedge funds"

Spengler is the pseudonym for David P. Goldman.
Goldman was global head of fixed income research at Bank of America (2002-2005) and global head of credit strategy for Credit Suisse (1998-2002).
From the Asia Times:
By Spengler
There's something deeply anomalous about a stock market crash at the peak of United States corporate profitability. Nothing like this ever has happened before. Nonetheless, judging from overnight moves in Asian markets, last week's plunge in world stock markets will be repeated in Europe and America on Monday morning - although recent intraday moves have been so extreme that one is loath to guess.

Standard and Poor's downgrade of American sovereign debt from the highest, triple-A rating may be the silliest pretext for a stock market crash in world history. America is the only big industrial country in the world that will have more taxpayers rather than fewer when a newly-issued 30-year bond matures.

Working-age population by region, assuming constant fertility

Source: United Nations

In Asian trading, the US 10-year note lost about a point and a half, a modest response to S&P's action. But the 3% to 4% declines in regional stock markets and a parallel fall in US stock futures, is harder to explain. Stock markets never have undergone this sort of crash when corporate earnings outpaced the alternatives by such an extreme margin. The earnings yield on stocks is a full 5 percentage points higher than the yield on 10-year US Treasuries, something we have not seen for a generation.

Equity risk premium (S&P 500 earnings yield minus Treasury yield)

Source: S&P

The so-called Equity Risk Premium (ERP) - the earnings yield on stocks minus the 10-Year Treasury yield - stands at a generational high. The corporate bond market assigns a low risk to corporate earnings. In a world short of earnings to fund history's largest retirement wave, why is the market selling an S&P earnings yield of 8% to buy 10-year Treasuries at 2.5%?

Systemic strains exist, first among them the likely restructuring of Italy's enormous government debt, but there is no reason for this to become a global liquidity event. Central banks stand ready to provide unlimited liquidity. There are good reasons to sell European banks. The American economy is weaker than the consensus forecast, and the US consumer may have dug in for the duration. But the link between US GDP and corporate earnings is the weakest in history, and 46% of S&P sales are outside the US.

If equity earnings are strong - and careful analysis reinforces the impression that they are - then we have observed a liquidity event like 1987 rather than a systemic crisis like 2008. The banking system, whatever its difficulties, is not the source of the liquidity problem, for banks have been reducing their holdings of risk assets for two years. Governments are not the source of the liquidity problem, for government stimulus in the West has been irrelevant to the economy since 2008.

There is, however, a bubble in the world economy. Anecdotal evidence points to hedge funds as the bubble that has popped. With equity hedge funds down 10.72% year-to-date on the Hedge Fund Research Index as of August 3, investors are demanding their money back. The debt-ceiling cliffhanger in Washington may have provoked the redemption calls, and the S&P downgrade might provoke more.

But the reason for the downgrades is that hedge funds have crippled out. Hedge funds can't earn the 15%-20% returns they promise investors in a world of 3% bond yields and 2% gross domestic product (GDP) growth. Investors desperate for higher returns, including pension funds, returned to the hedges during 2010 and 2011, and are now suffering spasms of buyers' remorse.

That prompted an across-the-board liquidation of all assets, including commodities and emerging market equities most favored by the hedges. The nearly $2.6 trillion of hedge fund assets constitute the system's only real bubble: too much money chasing too few returns, with a lot of fingers on the recall button. As of May, equity hedge funds with $1.25 trillion in assets had strongly net bullish positions....MORE