A Bearish Predisposition?

Via Pension Pulse.

From systemic risk of capitalism, we move on to more current events. I had lunch today with Greg Gregoriou,
a professor of Finance at SUNY (Plattsburgh) Greg has published many
books and articles, and his most recent article with Razvan Pascalau on
the optimal number managers in funds of hedge funds has garnered much attention.

Interestingly, while some major funds of hedge funds lost out in the crisis, assets from global pensions remain stable. Moreover, hedge funds are much more focused on meeting institutional demands:

Pension
funds globally typically allocated less than 5 per cent of their
portfolio to hedge funds or funds of hedge funds (while targeting an
allocation of 6-10 per cent), and while this share has increased over
the last few years, many expect it to double or triple in the years
ahead.

In the US, private sector
pension funds look to allocate on average up to 10 per cent of assets
to hedge funds, a little ahead of America’s public sector pensions,
which target about 8 per cent. In the UK, some of the biggest schemes
allocate up to 15 per cent of their portfolio to hedge funds. In
continental Europe, the take-up of hedge funds by pensions has been
more mixed, but pension funds in some markets, such as the Netherlands,
have embraced hedge funds and other alternative investment strategies.

The global economic crisis provided
only a temporary interruption in the growth of institutional
investments. Investors pulled about $300bn (£197bn, €232bn) out of hedge
funds between October 2008 and June 2009, but inflows returned to
healthy levels in the second half of 2009. Recent surveys by Credit
Suisse and Deutsche Bank suggest the industry may attract $200bn-$300bn
of new capital this year. It appears a large part of redemptions that
followed the 2008 crunch were from wealthy individuals rather than
institutions, and that institutions continued contributing new capital
throughout most of 2009.

As part of their own growth and
maturation, and in response to greater institutional investor demand,
hedge fund managers and firms of all sizes have become more
institutionalised in terms of their internal systems, structures and
general operational infrastructure. This can be seen in the use of risk
management practices and systems, compliance procedures, performance
and risk reporting, governance structures and overall operational
sophistication.

Institutional
investors demand the highest quality operational and risk management
systems from the funds they invest in, and to attract and in response
to investor feedback, hedge fund managers have developed sophisticated
asset management and trading infrastructures.

These demands have
required significant investments by managers in systems, technology and
people. However, the benefits to investors and managers outweigh
costs. The emphasis by investors and policymakers on transparency and
systemic risk analysis will serve to reinforce and continue this
infrastructure build.

The institutionalisation of the hedge fund
industry has been a developing theme for the past 10 plus years and is
likely to continue. It will also assist them to meet new regulatory
demands.

FINalternatives reports that three of New York City’s five public pension funds are mulling their first allocations to hedge funds.
So why the fixation on hedge funds? Part of it is gaining access to
top investment managers who deliver alpha no matter what market cycle we
are in, part of it has to do with the focus on risk management and
managing liquidity risk, and part of it is the whole fixation with
alternatives (hedge funds, private equity, real estate, commodities and
infrastructure).

Here in Canada, sophisticated public pension
funds are scaling back, being a lot more selective with the hedge
funds they partner up with, preferring to manage assets internally.

But
whether or not you farm out assets to hedge funds or manage assets
internally, you still need to understand the cycle we're in. Greg told
me he sees a repeat of the 1966-82 period where the Dow basically traded
sideways. He told me some of his colleagues at SUNY are working a
little longer before retiring, but they plan on "pulling their money out
of the market once the Dow goes over 13,000 again".

In his article, A Bearish Predisposition, MarketWatch's Mark Hulbert notes that advisers are not betting on a rally:

The stock market had its best day in over two weeks on Thursday, with the Dow gaining more than 200 points.

And
yet, the short-term stock market timers I monitor didn't budge: They
finished the day just as bearish as they were before the session began.

But,
when I recently went back and reviewed what the advisers were saying
then, one of their arguments stood out as providing a good illustration
of how excessive pessimism got the better of some of those advisers.

The
particular argument involved drawing a parallel between the rally that
began at the Mar. 2009 stock market low with the rally that began in
late 1929, following that year's stock market crash, and which lasted
until the following April. A number of the advisers I monitor drew
charts superimposing the post-Mar. 2009 performance of the Dow Jones
Industrial Average with the index's rally 80 years previously -- and,
upon noticing a superficial resemblance, predicted that the market would
continue to follow the same script this time around.

That was a very scary prospect, of course, since the Dow dropped some 85% from its Apr. 1930 high to its Jul. 1932 low.

Have
those advisers' worries come to pass? Not so far, at least. Almost
immediately after they began drawing the ominous parallels, it became
clear that the stock market was following an entirely different path. In
fact, the market today is about twice as high as it would have been
had it followed the script that so worried advisers last fall.

These
advisers' response? They just quietly stopped mentioning the alleged
parallels, focusing instead on some new found reason for concern.

In
any case, it should have been clear to everyone that drawing parallels
in this way is shoddy analysis. With over 100 years of daily data
available for the Dow, as well as countless more years of stock market
performance in other countries, one can fairly easily find any of a
number of past instances that appear to bear an "uncanny" resemblance to
the market's recent performance. And, yet, hardly ever is it the case
that the market behaved in exactly the same way following each of those
prior instances.

Of course, the
advisers rarely acknowledge that history doesn't speak with one voice
on a particular issue. Instead, they too often choose to highlight just
one of the historical parallels.

Their behavior reminds of a
famous remark attributed to Adlai Stevenson, the Democratic Party's
candidate for President in the 1952 and 1956 elections: He was fond of
mocking opponents by saying "Here's the conclusion on which I will base
my facts."

And
it's bullish from a contrarian perspective when the conclusion on
which advisers are basing their facts is that the market is going to
decline.

But the bears keep on growling,
reminding us that systemic, structural problems aren't going away
anytime soon. Bob Chapman of the International Forecaster notes this in
his latest comment, Talk of a Recovery Hides Collapse:

Talk
today centers around a stillborn recovery that never quite held on
long enough to materialize. Five quarters of 3% to 3-1/2% growth traded
for $2.5 trillion. Money and credit was thrown at the system again,
and again it didn’t work. Keynesianism at its finest.

The
housing purchase subsidies are gone, and real estate sales and prices
are again falling. Even with interest rates near 4-1/2% for a 30-year
fixed rate mortgage there are few takers in the hottest sales period of
the year. There are four million houses in inventory for sale or 1-1/2
years supply. That figure could be 5 to 6 million by yearend, as
builders’ build 545,000 more unneeded homes. More than 25% of mortgages
are in negative equity. Excess mortgage debt is $4 trillion and headed
much higher. Government is so desperate that they have begun to take
punitive action against those whose homes are under water, but they can
still make the payments, but are bailing out. What a disincentive for
anyone to buy a house. Will debtors prison be far behind?

There
certainly have been strategic defaults, but not as many as government
would have you believe. Twenty-five percent of all borrowers are stuck
with negative equity, which we expect will worsen. That could mean a
wealth loss of some $4 trillion. Obviously, homeowners are hoping for
higher prices. If that does not happen you can expect more walk-away
foreclosures. There are already four million homes for sale and many
more could be on the way. Plus, more than 500,000 more new homes are
being added to saleable inventory annually. Next year will be another
bad year for builders. Some will fail and others will merge. Government
is having ongoing meetings with three major builders in an effort to
nationalize the industry, as they will do with banking. Government is
doing the worst thing possible. It reminds us of Sovietization. The only
thing government has going for it is that underwater homeowners
usually do not default until they are down 62% from equity, but that
could change. Interest rates at 4-5/8% for a 30-year fixed rate
mortgage should keep them in their homes for now, but if interest rates
rise that plus could become a negative. That leads us to believe that
interest rates will stay that way for a long time. As a result the Fed
must keep interest rates at zero for a long time to have millions of
mortgages kept from falling into foreclosure.

At $15.3 trillion
the world’s holdings of US dollar denominated assets in ten years rose
from 60% of GDP to 108%. This in part has been caused by a
never-ending current account deficit. This factor alone makes one
wonder how the US dollar can be a strong international reserve currency.

In
just six years from 2001 to 2006, mortgage debt grew to $14.5 trillion
- a credit expansion unheard of in history. In the past almost two
years government borrowings have grown 49% just slightly more than the
45% in 1934-35. The Keynesian game is the same, it is just the time
frame is different.

Over a
20-year time frame total US credit rose from $13 to $52 trillion, or to
370% of GDP. A good part of these credit excesses have been exported
to the rest of the world and they are increasing exponentially; almost
160% just in the last six years, or to $8.5 trillion.

The
deliberate move to expose Greece’s problems, which those in government
and finance had been aware of for years, backfired and exposed all the
problems in Europe in the process. The impact of Greece, and the
elucidation of the depth of problems in Portugal, Ireland, Italy and
Spain curtailed the so-called global recovery and exposed extraordinary
weakness in the euro zone throughout the EU and Eastern Europe. That in
turn will ultimately cause problems for the US dollar and the pound.
There is now no question that the dollar rally is over and the question
is when will the dollar retest the 74 area on the USDX? The leverage in
banking is still 40 times deposits and we see no way to easily reduce
that. We believe dollar reflation will have to be the answer for the
Fed.

The financial terrorists
that inhibit our banking system and Wall Street still remain confident
that inflation caused by quantitative easing won’t show up for years,
if ever. What else can the Fed and ECB do except use stimulus? The
sovereign debt contagion in 20 major countries and as many creditor
countries, is not going to go away anytime soon. These are systemic,
structural problems. We certainly do not see the likelihood of the
dollar proving any safe harbor. Those who have flocked to the perceived
safety of the dollar are going to be very unhappy with the results.

Many
countries are enmeshed in major debt and in the case of the US the
debt is colossal. It is hard for markets to appreciate this in Europe,
the UK and US. The problems of the credit crisis are not over and there
won’t be a recovery, unless the Fed injects $5 trillion into the
economy. That will keep the economy going sideways for two years as
inflation rises. Small and medium sized business cannot get loans, so
they cannot expand and hire. About 23% of large corporations may expand
and hire. Offshore US corporations have far too much excess capacity
already. As you all know there are many speed bumps on the road ahead.
You had better be prepared for them.

Switching gears again, we
find very little coverage of the problems in Eastern Europe. Hungary is
a good example. Financial exposure is Austria $37 billion, Germany $32
billion, Italy $25 billion, Belgium $17.2 billion and France $11
billion. This kind of exposure to the banking systems of these
countries could be very painful. It will be interesting to see if
national governments, or the ECB step in as they did in Greece, and
manage the problems. The world should be paying attention because there
are 20 major countries in the same dilemma.

The
sovereign debt crisis is just getting underway as observed with
foresight. There has been no containment and 56% of Hungarian real
estate loans are in Swiss francs. The problem, which we have been
citing for some time, could cause a domino effect across Europe and we
wonder if the solvent nations and the ECB can handle the debt rescue.
Our answer is no. The next shoe to drop could be in this region and
surprise almost everyone.

Mr. Chapman isn't the
only one waiting for "another shoe to drop". Some market watchers point
to the recent weakness in the Economic Cycle Research Institute’s
Weekly Leading Index (a.k.a. ECRI WLI, see chart above) as evidence
that growth rate and stocks will continue to plunge.

But others correctly point out that the ECRI is pointing to a slowdown, not recession:

The
Economic Cycle Research Institute's Weekly Leading Index has been on a
downward trend since late April and has now hit a 49-week low, but
does that mean a recession is close? According to Globe and Mail, some
bears think so:

[The WLI’s] annualized
growth rate of negative 9.8 per cent is perilously close to a 10 per
cent decline, which the pessimists note has always been accompanied by a
recession.

The Wall Street Journal last week
quoted a British economist as saying the WLI is “very sensitive to
financial indicators … leaving it vulnerable to feedback loops from the
markets.”

Managing
director of ECRI Lakshman Achuthan, however, is hesitant to follow the
WLI blindly; he believes that predictions must be based on more
complicated indicators:

He
notes, it’s not a simple positive-to-negative swing that forecasts a
recession, making the BMO analysis oversimplified, he says. ECRI is
looking for “pronounced, pervasive and persistent” changes in the WLI.

And while David Rosenberg thinks a double-dip is imminent, Don Hays, founder of Hays Advisory Group, says a double dip is off the table and that the market will rally into the November elections.

My
own feeling is that the liquidity tsunami has not crested and will push
risk assets higher. Now that European bank stress tests are over,
expect them to join the party on Wall Street. I also expect banks will
start slowly lending again as employment growth finally shows some
sustained improvements.

Finally, keep an eye on some shipping companies that will be reporting this week (for example, Dryships: DRYS).
Any rally in shares of companies that are heavily leveraged to the
global economic recovery signals that risk appetite is back. In fact,
last week's one day bounce of Goldman Sachs and Amazon shares on the
day they reported disappointing earnings may be an ominous sign of
things to come. All those hedge funds desperately trying to find the
next big bubble -- and they aren't alone. Stay tuned, we might not need
QE 2.0 after all.

Comments

[SheepDog-One]

Shampoo what? ECRI has been around for 40 years moron, and I think that shampoo 'bifidus' is entering your brain! Suddenly all these permabull f'tards never even HEARD of the ECRI, but loved it when it was on its printed stimulus sugar rush higher. 

[Popo]

Firstly --  I challenge anyone here to make sense of your comment.  What are you talking about?  Shampoo what?

Secondly -- ECRI claims to be one of the most reliable predictors of crashes.  It is not the "perma bears" who tout ECRI's ability to predict crashes, it is the ECRI itself.