But frankly, what scares me more than risks we can’t control is the current impulse, from a governmental point of view, to try and do just that. Free market capitalism is still the most efficient and moral way for a society to organize itself, so one fears there may be medicine coming that, in the desperation for “an answer,” turns out to be worse than the original problem. Beltway panjandrums are surely enjoying this sudden windfall of authority. This is disconcerting, because the halls of Congress are not burdened with economic literacy. You might respond that this affliction runs high on Wall Street as well, to which I would say, touché. Like William Goldman once famously said of the movie industry, no one knows anything.
Let’s pretend we do and turn our attention to what’s ahead.
The Outlook for hedge funds...
Let me start this with something that will sound, on the surface, somewhat shocking: the outlook for hedge funds for the next few years is as favorable as I can imagine. Notice I did not say the outlook for the hedge fund industry, for that’s another matter. No one’s head is in a place, psychologically, where they’re ready to hear this, so the industry as a business will continue to suffer. However, as I ponder what drives hedge fund returns, I can come to no other conclusion than we are entering a multi-year period of 20%-like returns, starting probably after the next redemption cycle is complete at the end of March. Let’s go through the salient points:
1. Market volatility is high, but not crazy-high. Hedge funds like volatility because it causes investors to make sub-optimal decisions which, in turn, create price inefficiencies. Mind you, volatility like October’s – where all security prices are affected indiscriminately - makes it near impossible for anyone to operate. But this is very rare. Plain vanilla high vol is a good thing.
2. Somewhat related to the previous point, market inefficiencies are as glaring as I’ve ever seen. Bonds priced like the whole world’s going bankrupt, munis trading way cheaper than governments…it’s a long list. Understand that it’s not just that prices are cheap, it’s that they don’t make sense, particularly when compared with each other. This contrasts markedly to the generally “efficient” market we saw during the bull market.
3. Borrowing costs are at an all-time low. Almost all hedge funds borrow money to one degree or another. If a fund borrows 1-1 on its portfolio, a two point reduction in margin rates results in a two point improvement in its performance, all other things being equal. Almost no one is pointing this out.
4. The competition has gone ka-blooey (little bit of industry lingo, that). This is the biggest point of all, so just in case you forget points 1 -3, remember this one.
When I ran my own hedge fund, I got out in ’06 because there was just too much money in my strategic space. In my case it was quant, a sector that was being overwhelmed by the likes of DE Shaw and Renaissance. But the same thing was happening across all hedge fund sectors. Too much money reduces opportunity and increases risk. This is particularly true of spread-driven arbitrage strategies where everyone is looking at the same trades. But now the opposite is occurring.
Let me take you through some numbers as estimated by Peter Douglas, an industry professional based in Singapore. He estimates that until a few months ago, there was $6 trillion of “alpha seeking” capital in the world, $4 trillion of which was on bank proprietary trading desks and $2 trillion in hedge funds. The hedge funds, he figures, were levered 3 – 1 (on average) while the prop desks more like 20 -1 (if that seems like a crazy number, consider that Bear and Lehman were levered, as institutions, 30 -1). Do the multiplication and you get to $86 trillion of hedge-fund-like money in the world. No wonder it was getting tough to find good trades!
Douglas predicts a third of the hedge funds are vaporizing as well as 75% of the prop desks. This brings the number down to $24 trillion. But don’t stop there. Whoever’s left in the game will have delevered considerably. Douglas guesses hedge funds take it down to 1 1/2 – 1 and banks 10 – 1. This brings our number all the way down to $12 trillion, an unfathomable 86% decrease.
You can quibble with the numbers a bit if you want, but people I talk to think that he may even be underestimating by a bit. Whatever, the industry has all but disappeared, which makes me naturally think of…Bubba Gump Shrimp.
Shrimp Creole, shrimp gumbo, coconut shrimp…
I’m sure you saw Forrest Gump. If you didn’t, there’s a scene where Forrest and a friend, who have scrapped together some money to buy a shrimp boat, take it out in the middle of a hurricane. While this seemed foolish, all the boats tethered to their docks are smashed to bits, and Forrest finds himself with the only boat in the Gulf. All the shrimp were theirs for the taking, and the Bubba Gump Shrimp Company went on to riches and fame.
We’ve been pondering this a great deal in our office. Those able to stick around in the hedge fund business will get all the shrimp or, more precisely, feast on spreads big enough to drive a truck through. It will resemble the early-middle 1990s, the days before your cleaning lady quit to start a fund.
Interestingly, this bull market for hedge funds is likely to occur while the stock market goes nowhere. I don’t pretend to know where stocks are going, but this recession will be long and deep, so it’s hard to make the case for a bull market anytime soon. Big trading rallies, sure, but not a secular bull market. (Of course, as a naturally bullish person, I recognize my own possible utility here as a contrary indicator.)
Many people want to know how long the economic pain will last. First, let me say, that we no longer appear to be staring off the edge of the cliff the way we were in October, when we had a global counterparty crisis that could have ended much worse than it did. Think a run on all the world’s banks. It was close, maybe days away. Now, it’s not as if everything’s better, but at least it’s a problem that we can get our arms around, namely a recession. Recessions, unpleasant they may be, are a part of life. We’ve had them before, and we’ll have them again. This one will be a bad one, for sure, but at least the world’s not coming to an end.
So how bad will it be? I find a good starting point is some historical context. Here is what the recessions have looked like for the last 100 years or so:
Note that the average recession lasts 13 months. Our current recession actually started in December, 2007. I know it feels like it just hit this fall, but that’s the reality of it, according to the National Bureau of Economic Research, which means by February this recession will already be long in the tooth. Also note that with current unemployment rate of 7.2%, we have almost reached the average on that score as well. But no one thinks this recession is going to be average.
Our longest recession was actually the Great Depression at 43 months. I’m going to say this one will last 20 months or so, which would make it the longest since. But this means we’re out of it by July. Why do I say this? I am but an armchair economist, after all. But there’s just too much stimulus being thrown at the problem for the economy not to stir. In the Depression, they raised taxes and cut the money supply, both painful mistakes. Lesson learned. Bernanke, a student of the Depression, will juice the money supply like never before. He knows that given a choice of a bad recession and a depression, you take the bad recession every time. And Obama looks like he won’t raise taxes any time soon, despite his original plans. So, all in all, some nastiness for ’09 with 8-10% unemployment, if I had to guess.
It’s an open question, though, as to what awaits on the far side. Unfortunately, I don’t think it’s a v-shaped recovery. All in all, it looks a lot like…
The Me Decade
It’s always worth remembering Twain’s famous quote about how while history never repeats itself, it rhymes. In that spirit, let’s hope we see no more album covers like the one above (side note: the guy in the middle is my Congressman, whom, on account of my highly developed sense of fashion, I could not support). But there are some looming similarities between now and the 70s that are too pressing to ignore. The one that sticks out for us is the prospect for inflation. My partners and I think 10% inflation is possible a year or two out. (We don’t always agree, but we agree on this.) The printing presses will be working overtime to pay for everything that’s being promised. Many are also forgetting one other thing: the tidal wave of baby boomer entitlements that looms in the not-too-distant future. Keep those presses humming!
Another way to think of it is to ask yourself, who wins and who loses when inflation accelerates? In a nutshell, borrowers win, and lenders lose. Think of inflation as a wealth transfer from lenders to borrowers. Who is the biggest borrower in the world, and getting bigger by the second? The U.S. Government. Who is the biggest lender? After us, it is Japan and China. From a purely self-interested point of view, what would you do, if you were the U.S. Government?
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