Dan Loeb: "A Shift In The Market Has Occurred, We Are Adding To Our Short Book"

While most hedge fund managers and investors were skeptical about the direction of the stock market after Trump's shocking election victory, a few bet it all on green. One was Carl Icahn, another was Dan Loeb, and with the S&P surging by over 30% since the Trump victory, investors in Dan Loeb's Third Point reaped the profits of his conviction. However, after a quarter in which his fund posted an uncharacteristic drop and after an April which merely brought Third Point back to unchanged for the year...

... Dan Loeb writes in his latest investors letter that "a shift in markets occurred in Q1" which he describes as follows:

After a two-year period where growth surprised positively and inflation was benign, we began to see volatility in each of these areas.

Loeb's take on this "market shift" also explains why despite the best earnings season in decades, the S&P has been unable to turn green for the year: in a nutshell the recent surge in volatility has "increased uncertainty around  appropriate multiples" mostly as a result of confusion over what the new benchmark interest rate is and because "there is finally an alternative to equities in the form of relatively riskless two-year money." According to Loeb, this "riskless" 2-Year money which manifests itself in the form of a 2.5% Yield on the 2Y Treasury, has been observed in "money market flows where $400 billion has flooded in so far this year versus a total $80 billion of inflows in 2017."

There is another concern: according to Loeb, a major risk factor is how late in the credit/business cycle the US currently find itself:

"as manufacturing indices (PMI’s) cool from elevated levels, there is a real question about just which inning of the late cycle we are in. While we don’t believe a recession is close, there is definitely a concern that it is getting closer.

The bottom line: while earnings are stellar, there are growing questions about the other part of valuation, namely multiples:

Each of these considerations is weighing on multiples. For investors, this means the S&P is effectively range-bound and so, to generate profits, investors will need to adjust exposures more aggressively and successfully choose winners and losers across sectors."

And while talk is usually cheap, especially when it comes from hedge funds, Loeb is in fact following up on his growing skepticism with action:

We have responded to this regime shift in several ways. First, we have reduced net exposure by over 20% this year. We have taken about 15% exposure out of our long book and boosted shorts to about 25% of fund AUM. Last year’s focus on short selling after several years away from the strategy was a return to our early success as short sellers. We intend to further increase exposure to fundamental single names and quant-derived baskets in 2018 and rely less on market hedges to dampen volatility and reduce net exposure.

The billionaire hedge fund manager also had some observations on the relative valuation of equities vs credit:

"we are spending more time evaluating opportunities in risk arbitrage. While credit strategies performed well in Q1, we find most corporate credit markets are too richly valued relative to equities and so we have modest exposure to the asset class. As we discuss below in our structured credit update, we have been finding fewer opportunities in RMBS after selling most of our portfolio at a profit and are currently focusing on marketplace lending deals instead.

The rest of Loeb's letter was mostly laying out his rationale behind his new position in United Technologies, and an update of his bigger positions.

Loeb concludes conclusion shows that even the formerly bullish Loeb is turning increasingly concerned about the market:

Market shifts are inherently difficult to anticipate and when they happen, they do not ring a bell but they do blow a dog whistle, as we have said in the past. Our job is to listen carefully and to take decisive action when we suspect change is afoot. We believe that the increase in our short book and our reduced net and gross reflect what we are hearing.

Full letter below