Despite their name, most hedge funds today “are hardly even hedging; they are record net long equities in our analysis,” according to Crescat Capital’s May 2017 client newsletter.
“The reason hedge fund managers have become record net long equities is that they have been underperforming the S&P 500 for too long,” Crescat CIO Kevin C. Smith, CFA, said. “It is simply where we are in the investment cycle. When clients started pulling money out, the managers were forced to abandon their disciplines. I think many have capitulated to the long side in an attempt to stem the outflows.
“Also, I think a lot of managers have become genuinely bullish since the Trump election due to the prospect for tax cuts and less regulation under the Republican sweep. As such, they are not paying enough attention to the idea that it is very late in the business cycle with the Fed raising interest rates at the highest rate of change ever. Furthermore, while most managers acknowledge that financial asset valuations are high, I don’t think they realize truly how bubbly they are. They seem to think valuations will go even higher and the business cycle will be extended even further, Smith said.
Still, he added that hedge fund managers are more hedged than long-only active and index fund managers, “so they will fare better than these managers in the next downturn.”
In other news, the company’s research found that based on its study of prior post-World War II Democratic-to-Republican regime changes, there was a stock market crash and recession in the first year of the new Republican president’s term every time. “That’s right, every single one: Eisenhower (1953), Nixon (1969), Reagan (1981), and Bush (2001),” Crescat Capital wrote. “It’s still early in President Trump’s first year. He only just finished his first 100 days. Yes, even under the great Ronald Reagan, who ultimately delivered on his income tax cut, the world could not escape the curse of the stock market crash and recession in the first year of a Republican president.”
Smith noted that the current economic expansion is about eight years long, while the average expansion has lasted 5.8 years, according to the non-partisan National Bureau of Economic Research. This means the current expansion, based on the NBER average business cycle length, is 65% longer than the average expansion and “is due for a downturn, particularly now that the Fed is raising rates at a high rate-of-change and that we are in the first year of a Republican presidency.
“Understanding the extent of the overvaluation in financial assets today is a key part of reading the overall macro cycle, because it is when speculative financial asset bubbles burst that the downturn in the real economy follows. In the US, the aggregate valuation of financial assets (stocks, bonds, and cash) relative to after-tax income is more overvalued than it was in both the tech bubble and the housing bubble,” Smith said.
Crescat’s research also found evidence of an equity bubble based on the median stocks in the S&P 500 that “is at its highest valuation level ever, higher than the tech and housing bubbles on a price-to-sales basis. Furthermore, median debt-to-assets in the S&P 500 is at its highest levels ever, while the profit margin in the S&P 500 has already peaked out.”
It also noted major contrarian indicators, such as the high level of consumer confidence and a Barron’s Big Money Poll survey that found that only 9% of large money managers were bearish, while only 1% thought a recession was likely this year.
The hedge fund also noted that they are not “perma-bears,” but have changed their stance since 1Q 2017 because they “had bought into the idea of a possible late cycle inflection or ‘reflation trade’ and we even came out with a Peak Deflation theme. The facts have changed as our overall macro picture has come more clearly into view. What we see as we have laid out herein is not ‘reflation,’ but rather a significant downturn in the global economic cycle.
Tags: Crescat, equity bubble, Hedge Fund, S&P