Diamonds Amidst Rubble

A COP: “Anything else that’ll stop the elevator from falling?”

JACK:  “The basement.”

- From the screenplay for ‘Speed’ by Graham Yost.

It comes to something when you make a habit of watching the opening Normandy landings sequence of ‘Saving Private Ryan’ just to relax. Where conventional fund management theory is hugely deficient is in its almost complete absence of reference to the emotional impact of huge volatility, let alone both mark to market and realised losses.  As Mike Tyson once said, everyone has a plan until they’re punched in the mouth. Though to be fair, behavioural economics addresses the cognitive and emotional factors that affect investment decisions. And there’s a book on my bookshelf with the title ‘Judgment under uncertainty: heuristics and biases’. But you can tell it probably wasn’t written by Woody Allen.

Amid multiple markets (certainly not just equities) tossed so brutally and seemingly randomly this way and that, heuristics (”methods to help solve problems, commonly informally”) are one of the few things of practical use. To address the ‘why’ of volatility: presumptions that investors are pricing in horrific global economic contraction may be very wide of the mark, although global recession (of indeterminate length) looks like a done deal. The role of widespread hedge fund deleveraging is surely closer to the heart of the problem.

To address the ‘how’ of a pragmatic strategic response: short term policy rates are almost certain to be slashed. Notwithstanding future issuance, short-term government debt is the logical way for investors to play the anticipated monetary response. Yield curves are also likely to steepen to allow commercial banks to repair their balance sheets by borrowing at increasingly attractive short rates and lending long.

Away from the government bond market, battered equity markets are starting to reveal terrific promise. The logical reaction for investors looking to increase equity exposure (pound cost averaging also looks like the prudent way forward) would be to concentrate selectively on bombed-out growth stocks (the miners are a steal if valuations don’t deteriorate further), and to consider the time-honoured defensives: food; brewing; tobacco; utilities; consumer staples and in particular pharmaceuticals.

One of the first rational responses to a gale of fear and uncertainty is to try and remain calm. That’s the sort of advice you get during a nuclear air raid warning. But as John Hussman asks in an excellent edition of his weekly report,

1) How many people do you know whose bank has failed and have had any difficulty recovering their deposited funds? Anyone?

2) Do you personally know anyone whose money market fund has “broken the buck” and has not received the full assurance of the government that their claims will be paid in full?

3) Have you yourself had any difficulty making any transaction (not tightly related to your personal credit rating) in any aspect of daily life such as credit card purchases, grocery, gas, shopping, or for any other purpose?

John also suggested that:

The only thing we have to fear is the fearmongering of Wall Street itself.

Look - a few weeks ago, there was a $700 billion pile of money on the table, but the only way for Wall Street and bureaucrats to get their paws on it was to scare the public out of its collective gourd. They succeeded, but created the psychology that the U.S. was on the verge of depression if the bailout wasn’t passed. Having created that psychology, the crisis took on a life of its own.”

The next stage of the crisis, however, is real, inasmuch as it reflects the unholy mess that is the impact of Lehman’s (LEHMQ.PK) bankruptcy (and other shock financial dislocations) upon the hedge fund industry. HFRI index returns for 2008, an almost unbroken wall of red ink, only show part of the pain; with redemption requests falling like autumn leaves, many of the more leveraged (and / or dumb and / or simply unfortunate) players will be fighting for their survival and selling assets wherever they can.

As Paul Kedrosky points out, the great hedge fund unwind is under way. The investment media are not necessarily reporting the underlying reality behind current market action. Savaged equity prices may be reflecting fears about recession, but an altogether more plausible answer, as Paul suggests, is that:

the selling is about broken hedge funds being forced to sell whatever is liquid to respond to margin calls, and equities are more liquid than anything else they own, so they get sold.

And with 3,500 hedge funds reportedly receiving margin calls from PwC while their assets are frozen in the wreckage of Lehman Brothers, and with plenty of panicked investors issuing redemption requests now and asking questions later, the great hedge fund unwind - with all its attendant volatility across multiple asset classes - will be with us for some time to come. So if the markets are overdue a bounce, that recovery will not exactly manifest itself in the form of an orderly straight line.

This will, in time, leave the very best hedge funds in a uniquely advantageous position. Their rivals will be liquidating themselves out of business while Wall Street proprietary desks - those that are left - will for an extended period be just a faint shadow of the belligerent force they were before.

These developments also leave private clients well positioned relative to their institutional peers. Unlike long-only institutional funds and hedge funds, private clients don’t have to report their performance figures - to anybody, over any time period. But like banks, private clients can also engage in the miracle of maturity transformation - essentially, by converting their ongoing income into longer term investments by means of their savings and pension funds. The financial storm may not have abated (note the anticipated further waves of hedge fund deleveraging), but the bulk of its fury is surely now spent. It leaves in its wake a number of hugely attractive opportunities in the equity market.

When stocks like BP (BP) are available at forward price / earnings multiples of less than 5, and when the entire Japanese stock market is left trading close to book value at levels, in real terms, equating to where it traded in the early 1970s, one has to wonder whether private clients look very well positioned by comparison to bombed out hedge funds and sickly prop. desks who are either unable or unwilling to take on long-only bargains. Sensible asset allocation is still warranted, of course, but as regards the big picture: fear is still widespread, and valuations have been indiscriminately thrown around. Time to get, selectively, greedy.

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