A bout de soufflé

I don’t know if using French in a blog title has the same effect as using an equation in a book – that of guaranteeing to halve your readership. But I guess I’ll find out later today. It’s the title of the classic new wave Jean-Luc Godard movie from 1960 – starring Belmondo and Jean Seberg. And it translates as ‘breathless’.

That strikes me as just the right phrase to describe a bunch of emerging markets nowadays, and probably a bunch of hedge funds too. They’ve got so big, they are struggling to breathe under their own weight.

I like to watch how the average hedge fund manager behaves. It doesn’t matter how eclectic they all are, whether they’re trying to shoot out the lights, or to hug low volatility to gain assets under management. From 2003 to October 2007, the aggregate hedge fund performance indices all behaved in a certain way. They behaved as if they were a mechanical leveraged long position on the S&P 500, with a trailing stop.

Now, when I discovered this in early 2006, I thought it was ridiculous. Why pay 2&20 for something you could run with a two line spreadsheet model? But lately I’ve thought about it some more, and I’ve changed my mind.

There’s a good book by New Yorker columnist James Surowieki called the ‘Wisdom of Crowds’ – that I’m sure many of you have read. In it he describes how that, if you average out the responses from a group of random people at a fair guessing the weight of a cow, well, you get a more accurate result than if you ask a individual expert; a farmer or a butcher.

And so with hedge funds over the period. The most efficient way of trading the market from 2003-October 2007 was leveraged long stocks with a trailing stop. Amazing really, that all the thought, all the emotion and all the complexity in markets over that period could be reduced to such a simple formula.

That changed in November 2007, when hedge funds held up, despite a fall in the market. That was very interesting – it was the first sign of a change in behaviour in over four years.

Then we had Q108. And the funds got toasted. It was the worst performance quarter on record – as equities collapsed, rebounded, collapsed and started to rebound again – all in three months. But, according to Hedge Fund Research, Hedge funds have now made up, in April and May, all their losses from Q1.

So on average this year, the funds are back to leveraged long with a trailing stop. The way they’ve been for around 61 of the last 62 months.

Now what all that tells me is that funds are struggling to adapt. They’ve got a tendency, on average, to revert to the lucrative behaviour of the 2003-7 years. And that’s probably why, when I got cautious a little over a month ago, the market kept running for a few weeks, even as the risk/reward of going long had deteriorated. Funds were reverting to the leveraged long trade, stops on short positions were getting hit, and there was a tendency to get on the momentum, to make up the losses of Q1.

But like any organism that has taken such massive advantage of its environment – the funds have grown to the point that the environment can no longer support them in their present form. Returns have been falling. Hedge funds, on average, will now have to adapt or die.

My own view is that, with the weight of money – and the likelihood that the overall pool of funds will shrink – it is very unlikely that leveraged long with a trailing stop will prove the most efficient way to run money over the year ahead. The adaptation I expect is this; funds will end up doing the opposite. Leveraged short with a trailing stop. And the earlier they do it, the larger they’ll get. Indeed, I suspect some of the funds that have blown the lights out – and gained assets over the last twelve months - are predisposed to behaving this way.

And that got me to thinking about what to look for in this environment.

That comes back to my title at the head of this post. When the global economy was recovering from a point in 2003 at which resources, globally, were grossly underutilised (we were back at 1982 lows) - everything could reflate. Housing, property, resources. Everything. And capital flows from East to West and the convergence of Eastern Europe helped to prolong and exaggerate the process.

But that dynamic – which generated an incredible uniformity of performance across risk markets - hid some profound differences.

Don’t laugh, but I like to keep things simple. I think a good way of categorising countries (and sectors if you like) – is to split them into inflators and reflators. An inflator is a country that’s pulling in large resource dollars for fundamental reasons (described in my presentation – crowded house). A reflator is a country that has pulled in large amounts of capital for investment in local bonds, credit, commercial and residential real estate.

Obviously, there are shades of grey. If an inflator country allows its credit to expand rapidly – say above 3x GDP – then it’s a wild inflator. Russia, Dubai and the UAE fall into this category. If a reflator still has good returns on capital, a current account surplus, and credit growth of less than 2x GDP – then it is a conservative reflator. China is a clear example. If a reflator has blowout current account deficits and rip-roaring credit growth – like the Ukraine, Vietnam, Latvia and co – then they are wild reflators.

And the reason these distinctions are useful, is that all these countries are going to have to adapt to the current environment in very different ways. The first to run out of breath will be the wild reflators. My view is that the oxygen is already scarce.

Not just financial oxygen either. The inflator nations aren’t just selling high priced oil. They are using the funds to subsidise a massive expansion of domestic oil consumption and growth (oil exporting countries, that make up less than 15% of world GDP, account for more than 50% of oil demand growth). Smells like a self-reinforcing process to me – one that starves consumers and corporates of air in reflator nations.

On the principle that two shocks are more than twice as bad as one – we now have to deal with – I’d say – five major shocks;
1) The original structural problems with the winding down of bank disintermediation and deteriorating asset backed securities in reflator nations.
2) The breakdown of the wholesale banking model as libor/base rate spreads widened.
3) The self-reinforcing crowding out of consumers in reflator nations by inflator nations – and a subsequent slowdown.
4) The deterioration in credit generally and property loans in particular in reflator nations as a result of 1, 2 & 3.
5) A reversal of speculative funding in assets in reflator nations due to 1,2,3,4 and due to a change in fund behaviour.

In my experience, markets can and do price in bad news. But markets are very bad at pricing in self-reinforcing negative processes like the ones described above. There’s still a long way to go on the short side.