Outperforming the averages over a market cycle while earning significant positive rates of return are the main criteria for a successful hedge fund manager. And, as we all know, that begins with managing risk.
The collapse of the financial markets in 2008 reinforced risk management to a fault and, as such, hedge managers as a group have underperformed the averages for the last seven years.
A successful hedge manager must know when to hold, when to cut back exposure, and finally when to fold—go flat or net short. Unfortunately for their investors, today's managers have not recognized change in the investment landscape that has influenced investing over the past seven years that will impact us for the foreseeable future. Recognizing change and new trends creates tremendous opportunities to make money in all financial markets. Hedge fund managers are cynical to a fault.
I wrote last Wednesday in "Investing For All Seasons" that there appears to be no real conviction for the future and the markets continue to increase on a Wall of Worry. It is important in these times to connect to your core beliefs to guide your asset allocation and specific investments.
Here Is What I Believe
Monetary policies are easy virtually everywhere, interest rates are surprisingly low and will remain so for the foreseeable future; the supply of funds exceeds the economic demands for funds, which is beneficial for financial assets. The dollar is the currency of choice, global economies remain sluggish at best, government policies and lack of credibility hinder confidence at all levels, holding back growth and needed investments, corporate earnings are stronger than expected, except in commodity related industries. Commodity prices will remain under pressure as long as supply exceeds demand, M&A activity will remain high, speculation exists mainly in real estate, private equity and art, skepticism is everywhere and, finally, many companies are making strategic changes to enhance their future returns on capital, cash flow, free cash, dividends and stock buybacks and are acting are their own activists.
We are living in a new economic period, with lower highs and higher lows, where the landscape for investing continues to change, creating opportunities to make money on both the long and short sides of the markets. Invest to catch this new trends rather than trading on every data point of news.
Let's review the events of last week in the context of my core convictions:
1. Revised first-quarter GNP was reported Friday and showed a decline of 0.7 percent vs. the prior period, which was fully anticipated. While the trade deficit was larger and inventory build smaller than earlier projected, corporate profits grew 3.1 percent and were up a surprisingly 9.2 percent from a year ago excluding inventory valuation and capital consumption adjustments. Inflation data was well beneath Fed goals: the PCE fell 2.0 percent and prices, excluding food and energy, rose less than 0.8 percent. Consumer purchasing power increased, as evidenced by rising incomes and a sharp increase in the savings rate to 5.5 percent from 4.7 percent.
While we still expect a snapback from the weak first quarter, it will not be as strong as we previously anticipated for a number of reasons that all circle back to a lack of confidence at all levels. Consumer confidence fell to a six-month low in May to 90.7; the Consumer Comfort index fell to 40.9; the Chicago PMI fell more than expected and order for durable goods fell while pending house sales rose, orders for capital goods rose and business lending by banks is finally increasing.
Fear of an impending increase in the Fed funds rate has corporations and individuals concerned. The general consensus seems to be that once the Fed starts raising rates that we are closer to the end of the economic recovery. Therefore, to stay ahead of the curve, it is prudent to hunker down and prepare for the next downturn. How ironic that Fed talk is impeding growth rather than supporting it.
It is time for the Fed to stop preparing us for the first rate hike and to start instilling confidence in the future of America.
2. Greece, Greece and more Greece is the news out of the Eurozone. How repetitive, week after week. The financial markets are over influenced by the daily volleys back and forth between members of the ECB and the Greek government. The G-7 meetings held last week were to focus on implementing policy changes in the region to support longer-term growth but, instead, the focus was on Greece.
Time to face reality that Greece cannot live up to the terms of its deals with the ECB, so either revise them and provide an opening for other troubled countries to revise their terms, too, or let Greece exit the euro. This daily chatter is hurting confidence in the Eurozone and is finally impacting business. Growth has stagnated recently, interest rates have fallen again and so have the European bourses.
Greece, by exiting the euro, will only strengthen it, and that may be the rub for the ECB and Germany. A weak Euro is good for exports and growth. So watch Greece to get a better handle on investing in Europe. Afterwards, the G-7 can focus on policies to create a better economy throughout the Eurozone for the foreseeable future. Not yet, so all the pressure remains on Draghi and QE to support growth in the interim.
3. China is trying to balance short-term stimulus to bolster the economy with long-term policy changes to build s stronger and sounder foundation for years to come. The government clearly recognizes that past policies led to excessive lending, debt and margins but also new policies to curb them have impeded growth. Just this past week, brokerage houses raised lending restrictions while the central bank drained reserves. The Shanghai composite fell nearly 10 percent. While clearly this hurt short term, these are the needed policy changes for the future. China continues to lower barriers for foreign companies to enter the market; its easing capital restrictions to further internationalize its currency and are reducing import taxes to boost spending and growth. I like what I see and remain positive longer term on China.
4. Economic statistics out of Japan were weaker than anticipated. Consumer spending was just not good despite recent employment and wage gains. Inflation has slipped backed to zero too. Unemployment is at a multi-year low of 3.3% and there are 117 jobs available for every 100 job seekers. And industrial production is rising due to the benefits of a weak yen increasing exports. I remain optimistic on Japan as Abe's pro-growth policies and a very easy monetary policy both support longer-term growth. The Japanese markets continue to hit new highs.
5. Energy prices stabilized at higher levels last week as inventories declined despite higher production. As we discussed in earlier pieces, many of the shale projects put on hold will start up again as prices go over $60 per barrel which ironically will cap any further price gains without a meaningful increase in demand. After dropping dramatically, the U.S rig count has stabilized at lower levels. It is too early for Saudi Arabia and OPEC to take a victory lap hoping to stem production gains in other regions due to low prices. And don't forget Iran in the bushes if a deal on nuclear containment is reached.
Let's Wrap This Up
The prospects for growth remain sluggish although better than over the last few years, monetary policy will stay easy including in the U.S as I expect the Fed to be on hold until year end at the earliest, inflation and interest rates will stay subdued, the dollar will remain the currency of choice, excess liquidity will find its way into financial assets, corporations and individuals will maintain a conservative tilt until confidence returns both here and abroad, commodity prices including energy are range bound at lower levels until there is a meaningful pick up in demand, Greece will be settled one way or another clearing the market of an overhang, the Shiites and Sunnis will continue to battle and the U.S is powerless to influence events in the Middle East, the populace will move into the center right as past policies of the Democratic administration have not succeeded and finally corporations will continue to make strategic changes to survive and even thrive in a slow growth environment. My major concern remains stagnation or further economic weakness rather than overheating, rising rates and higher inflation.
It remains a positive time for financial assets. Bond yields cannot go much lower and I'd rather own stocks in companies with rising earnings, cash flow and dividends with yields today over 2.5 percent, which exceeds the current 10-year bond. Infrastructure remains a major theme in my portfolio, as the need to improve and expand infrastructure spending is a worldwide phenomenon. Look for the best companies and be agnostic as to where they are domiciled, as globalization is a fact of life today. And finally control risk by maintaining ample liquidity at all times. The positives in the economic landscape far outweigh the negatives so do not be cynical to a fault.
