Columbia Business School 2014 – Under Construction
Author: Greg Blotnick
Greg Blotnick is currently a long/short equity analyst at a private investment firm and covers the Consumer sector. Blotnick holds an MBA from Columbia Business School and a B.S. in Finance from Lehigh University, and is a CFA Charterholder.
Opinion: Investors are dumping hedge funds just when they’re needed most – Greg Blotnick
Hedge funds today are about as welcome as a stick in the eye.
Endowment funds and pension funds are reducing allocations en masse in favor of indexing and private equity, as outflows reach levels unseen since the financial crisis. Harvard University plans to fire half of its endowment staff and shut down its internal hedge funds amid underperformance.
While some of the disdain is deserved, there are a handful of misconceptions about hedge funds — particularly long/short equity — among the media and investors that are worth clearing up. The key takeaway is that redemptions are rising just as hedge funds are well-positioned to outperform. Long/short funds use leverage, derivatives and short positions in an attempt to make money in any market condition.
Hedge funds have been around since Alfred W. Jones first hung a shingle in 1952, but their popularity (as measured by assets under management) picked up in the 1980s and accelerated after the Nasdaq COMP, +0.15% bubble popped in 2000. The zeitgeist of the era, as well as the “secular vs. cyclical” debate, is captured in historical articles by Forbes and our very own Wall Street Journal.
In the late 1990s, sentiment was poor following Long-Term Capital Management’s collapse in 1998 and became exacerbated as many funds underperformed during the meteoric stock market rise of 1999. A cyclical bottom was marked as industry patriarch Julian Robertson closed Tiger Management in 2000 — which was the second-largest hedge fund only three years earlier — just months before equities collapsed.
Long/short funds, as one would expect, trounced the market over the following few years, delivering 16% returns in 2000 with the S&P 500 SPX, +0.07% down 9%, 5% returns with the S&P 500 down 12%, and minus 2% returns with the S&P 500 down 22%.
Sentiment began to shift, with the WSJ remarking in mid-2002: “Both the Dow industrials and the Nasdaq fell to fresh lows Friday, and given the performance, investors are hunting for places to put their money where it won’t evaporate. Hedge funds, on the surface, seem like a natural choice, given that they’ve outperformed the market for the last two years.” The industry’s assets under management grew 38%.
Three months later, the Journal noted: “Hedge funds are viewed as a way of making money even when stock prices are in decline, making them particularly attractive to some investors now.” A similar dynamic played out after 2008 as long/short equity funds returned minus 12%, lower than the S&P 500’s minus 37%.
So even professional investors and allocators suffer from recency bias — people most easily remember something that has happened recently — and think to add downside protection only after a stock market crash. We are seeing the inverse of that today.
In this long bull market — which turns eight years old next month — hedge funds by nature will underperform, yet investors continue to benchmark performance as upside capture versus the S&P 500 — which is a misunderstanding of how most long/short funds operate. The product writ large is designed to reduce a diversified portfolio’s correlation to the market, lower standard deviation (thus increasing a portfolio’s Sharpe ratio) and ultimately deliver long-term returns in excess of the market. Investors today are redeeming money from long/short funds when those investments are likely to be needed most.
Greg Blotnick is a long/short equity analyst at a private investment firm covering consumer, TMT and industrial stocks. Blotnick has spent his career in the asset-management industry and served as a fundamental analyst for former multi-billion dollar hedge funds. He holds an MBA from Columbia Business School and is a CFA charter holder. Follow him on Twitter at @Greg_Blotnick.
“CORRELATIONS HAVE CRASHED: Editors at Morgan Stanley won’t let analysts use the word ‘crash’ without a good reason and its best way to describe what has happened since election across globe…regional correlations, cross-asset correlations and individual stock and FX correlations have fallen simultaneously. That’s unusual; we haven’t seen a shift this severe in over a decade. There are several reasons for this. One of them is that deep into an expansion, higher economic confidence reduces the likelihood that many markets will panic at the same time, and means market-specific stories are often bigger drivers than the more binary question of ‘recession, or not?’ Positive and negative effects of this…on the plus side, it should be a better backdrop for ‘macro’ trading. But as correlations fall, the risk that a hedge won’t work also rises. Correlation pricing has diverged most from historical norms in: AUDUSD, gold, Japan equities, EURUSD and EUR rates…so those offer some of best opportunities to position for higher volatility and higher correlations. We like USDKRW and USDJPY longs for the bear and bull case tail scenarios on still-respectable correlation with global equity risk. Small caps (Russell 2000) and to a lesser extent Nikkei and EM equities in stocks all have below-average vol and correlations today to S&P 500; makes index hedges cheaper, although the lower level of realized volatility means consensus is looking for an even better entry point to buy equity vol.”
The drivers of this matter, and we’ll touch on them briefly. But we’ll focus most of this
report on the implications, specifically:
Not a fluke: Correlation lower at all levels
The sharp drop in cross-asset correlation is not a fluke. It represents a decline in
correlations at each of the three key ‘levels’ that we care about – cross-asset, crossmarket
and intra-market. Our correlation indices (Exhibit 2) focus on the first two of
these, while the last is an important addition.
1. Lower correlation should mean a better ‘macro’ trading environment (since each
market isn’t the ‘same’ trade). It is a mixed blessing for diversification, lowering
overall portfolio volatility, but also making hedging through ‘proxies’ harder.
2. Lower cross-asset correlation is common in ‘late cycle’ environments, fitting our
preference for equities > credit. Meanwhile, USDKRW remains our favourite ‘proxy’
hedge in a lower correlation world, given its linkages to several macro risks.
3. We’d expected correlations to rise again if growth data disappointed. Since lower
correlation has helped to depress volatility, hedges that benefit from both
correlation and vol moving benefit from unusually good pricing now. Our
favourites are AUDUSD, gold and EURUSD.
The US Dollar is the “grand unifying theory asset” for nearly any and all “profile” global macro or thematic equities trades in the marketplace right now, as it represents investors being long this “new” version of “economic growth.” As such, performance is significantly tied to the direction in the US Dollar.
SO THEN…let’s take it back to the “January Effect.” I’ve been doing a bunch of client marketing this week, with the ‘meat’ of the discussion being largely centered upon buy-side concerns surrounding said “seasonal mean-reversion” metastasizing into something larger. I qualify this as “something larger,” because at this time, NONE of the YTD performance reversals from Q4 have been outright PNL destroyers. Sure, popular shorts like USTs / ‘long duration,’ EM stocks, gold and equity ‘growth’ factor are all squeezing higher out of the gates—but by and large, so too are popular longs like small cap equities, inflation, copper, ‘high beta cyclical’ equities, ‘value’ factor and HY.
The fact is, there has been a ton of money made / performance driven by, for example, ‘long Russell 2k’ vs ‘short USTs’ / ‘short ED,’ or being long equities ‘value’ against short equities ‘growth’ since back mid 2016 when we began seeing positioning pivot this way (and accelerating post-Trump). But the problem is that for many, much of that positive PNL was booked last year. So an ‘upside-down out of the gates’ January is more than inauspicious—it’s an outright “non-starter” for risk managers in light of the performance-challenged era of the past few years. Fund willingness to stomach slow starts in January to begin the year—especially in light of the proliferation of ‘tight stop’ multi-managers with a massive institutional AUM concentration, and a pod / center book structure which exacerbates crowding—can “turn wrong-way fast” when CRO’s become de facto heads of trading into potential deleveraging.
OKAY, SO BACK TO THE US DOLLAR. A macro trade entirely built around the framework of “US domestic growth and reflation” + pro-business policy mix + a sprinkling of “animal spirits” = long Spooz / long Russell / long value vs growth / long cyclicals vs defensives / short FY / short Eurodollar futs (largest net spec shorts ever recorded per last Friday’s CFTC data) / long CNH / long copper vs short gold / short EM / short EUR / short Yen’ again almost singularly hinges on the Dollar.
(As an aside: believe me, I ‘get’ that it seems counter-intuitive that a reflation trade would be positively correlated with the USD….but as the Trump story is about DOMESTIC growth (indiv and corporate tax cuts, fiscal spending, border adjustments and potential tariffs which restrict flow of cheap goods = PUREPLAY domestic inflation…higher Dollar is key to perpetuating the current regime.)
If we see the Dollar materially weaken from here, the entire trade is in jeopardy.
From a “consensual positioning” perspective which touches on this current “mean-reversion dynamic in the marketplace: say this big bond rally were to gather steam into a much more punishing squeeze of the ‘all-time’ UST short base (largely due to the previously mentioned lack of “tolerance” for beginning of year performance pain). Yields would collapse and likely drag the USD lower with it. Above trades would likely unwind as well.
Fundamentally with the USD bull-case, this is a large part of why there is SO much focus on key items like the border-adjusted tax element of the Trump policy push. A large part of the Dollar’s strength (beyond ‘just’ the data) post- the election has been based upon this, where if the corporate tax rate were cut to say 20%, the Dollar would by economic theory have to then appreciate 20% (and of course too, an additional ‘tax factor’ driving the USD bull-thesis is that a meaningful chunk of $2.5T of profits held overseas by US corporates would be repatriated following a ‘business friendly’ incentive package / one-time cut to the repatriation tax to say 8-10%).
There is a view though within some verticals of the business community is that the border-adjusted system represents a very significant risk (consumer retail most notably) to their businesses / the broad economy as imports become more expensive and will create trade distortions (while the CBO itself says that the border-adjusted system would NOT reduce the trade deficit, which is a driver of its political popularity). There is so much discourse on this issue currently on this topic within the C-suite in fact some in policy circles are now saying they believe it appears increasingly likely that the ‘full’ border tax adjustment (currently in the Houses’ version of the bill) ends up being watered down to a sort of “relocation penalty” (which would likely then appear in the Senate-version of the bill).
Again, this is all a hypothetical, but if some of this ‘sense’ around said USD ‘bull driver’ turning potentially bearish was to ‘leak’ into the market, it would take some of the air out of the “long USD” trade–and that is where things could go off the rails. If the Dollar broke lower, its likely too that bonds and duration would rally; defensives (staples, utes, reits) and growth (tech / biotech / discret) squeeze against crowded value unwinding (fins, energy, indus); yen and euro would squeeze mightily; gold squeezes while copper pukes in a favorite commodities ‘pair’ unwind; HY could reverse weaker vs IG (currently everybody long CCC vs BB on the high beta trade)…this would be the theoretical path to our next pain-trade or even VaR shock.
As such, status quo positioning and thus performance is ALL about ongoing strong data trend, more than any other quarter in recent memory. And boy do we have lots of it recently—some repeated highlights, with updates–
Key global economic metrics shows a hugely bullish ‘growth’ backdrop:
Citi’s G10 Surprise Index at 3.5 year highs;
The Emerging Markets Surprise Index at 5.5 year highs;
S. Average Hourly Earnings growth YoY at 7.5 year highs;
S. ISM Prices Paid at 6.5 year highs:
Global Manufacturing PMIs at 3 year highs;
Global Services PMIs at 1+ year highs;
G10 Inflation Surprise Index at 5+ year highs;
China PPI YoY at 6 year highs (high correlation / feedthrough to US CPI YoY AND China GDP);
And then the animal spirits stuff:
NFIB US Small Business Optimism Index at 13 year highs;
16 year highs in US Consumer Confidence;
US Homebuilder Confidence at 12.5 year highs;
CEO Confidence 3rd highest reading since ’07;
Take a look at this random assortment of data beats over the past week alone:
China Caixin Manufacturing PMI at 4-year highs;
Fastest expansion in the Chinese production and output growth sub-components in 6 years;
Eurozone Manufacturing PMI at highs since April ’11;
UK Manufacturing PMI at 31-month highs, while Service PMI beats and hits highest level since July 2015;
On a per country level within the EU Manufacturing PMI dataset, the Netherlands-print was 68 month highs: Austria, 68 month highs; Germany 35 month highs; Spain 11 month highs; France 67 month highs; Italy 6 month highs; Greece 4 month highs;
Hong Kong Composite PMI hits expansion for the first time since Feb 2015;
Beats and multi-year highs in German and French CPI prints;
Japan Service PMI hits 1-year high;
Australia’s AiG Service PMI rises to highest level since 2007;
German Retail PMI increases back into expansion;
Eurozone Retail PMI higher and back into expansion;
UK Industrial Production overnight seeing a top 5 MoM print experienced over the past 20 years;
So we have that going for us in a major way…but how long can this momentum last now that we’re in the ‘hard part’ of the trade and the ‘implementation challenges’ await on the policy side?
It need be noted that this “USD reversal lower as largest risk” thesis comes against the supporting ‘reversal context’ of short-term tactical opportunities TRADING AGAINST REFLATION within rates, curves, EM and gold for instance (highlighted by my colleague Mark Orsley this morning), which is taking advantage of technical reversals / loss of Q4 trend momentum. And of course too, if all of global rates were to ‘countertrend rally’ in unison (largely on technical), it is possible that the USD might not end up moving much at all as differentials remain static.
Nonetheless, 1) the rates move lower on positioning excess being unwound due to YTD performance pain and reversing technicals, along with 2) the potential “watering down” of the tax policy’s USD-drivers need be monitored going-forward for all portfolios due to the high likelihood of causing a similar turn lower in the US Dollar.
“Good Morning! US Futures are starting slightly under pressure, confounding the peeps on CNBC wearing their Dow20,000 hats. We have pretty much a sea of red across Europe, with the DAX off 55bp in a market that sees Fins and Energy lagging. Multiple Italian banks are being halted limit down, hitting the MIB for 1.7% in the afternoon hours. The weaker pound helped post a fresh FTSE record, with Miners propelling London. Volumes are relatively light – with most exchanges trading ~30% off normal trend. Quiet overnight in Asia as Japanese markets were closed for a public holiday – China gained 50bp as HIBOR fell – Aussie enters a bull market, climbing almost 1% as the Big Banks Rallied, while all of EM was in the red as the Greenback caught bid.
Hawkish comments from Fed’s Evans and Williams had the US 10YY higher early, but with the German 10YY retreating from 3week highs, we are seeing most Sov Bonds bid (Yields lower). The Greenback is recovering the bulk of last week’s losses, with the Euro weaker despite German IP and Exports better than expected, and Euro Unemployment coming in at 7year lows – Sterling falls to October Lows on Article 50 headers – Turkey’s Lira fresh record low on Moody’s, Peso eyeballing lows into Auto Show Headers. With the stronger $, damn interesting to see GOLD higher, while Industrial commodities are taking a breather from last week’s ripsaw. Oil getting hit for 2% as US Producers add more rigs and Iran ramps exports, while Natty Gas drops 1.5%, adding to last week’s losses.
Ahead of us today, we have Fed’s Roesengren speaking at 9 – Bank of England Bond-Buying Operation Results post at 9:50 – the Bank of Canada Senior Loan Officer Survey hits at 10:30 – Fed’s Lockhart Speaks to the Rotary Club of Atlanta at 12:45 – and we get Consumer Credit at 3. Eyes on Healthcare as JPM’s Conference in SF gets going – while multiple airlines post December PRASM Numbers. Retailers in focus this week with the ICR Conference kicking off tomorrow in Orlando, ahead of Advance Retail Sales for December on Friday. Earnings focus is all Financials – BAC, BLK, JPM, PNC, WFC report Friday pre-open.”
Our S&P 500 target is 2,400 in 2017 with no recession seen until late 2018
Our S&P 500 target is 2,400 in 2017 with no recession seen until late 2018. The S&P 500 continues to act as if Fed exit began in May 2014 during the QE3 taper and we expect the Fed to “over-hike” and trigger a slowdown and bear market at a surprisingly low fed funds by 2018-19E. Thus, we see both ~2,400 and ~2,000 for the S&P 500 in the next 3 years. We forecast reflation trades (Value vs. Growth) peaking with S&P 500 y/y EPS momentum 2H 2017E ($125 EPS in 2017E +15% y/y, Street $131), led by Financial, Industrial and capex stocks. History also shows that the risk-on trade (and S&P 500) skews toward November to April performance, so our advice is to “sit tight.” Policy settings remain critical after a near recession/premature tightening in 2H14-2015, but we detect a more careful Fed and fiscal help in 2017, watching long-term inflation expectations, the U.S. dollar and yield curves as we await synchronous global GDP growth.
Canaccord / Tony Dwyer – bullish but waiting for pullback to buy
“Staying neutral in anticipation of opportunity. On December 19 we downgraded our market and sector view to neutral in anticipation of a digestive period in the markets. We continue to have a very positive fundamental intermediate-term view, but believe (1) the improved economic data, (2) fear of higher interest rates, (3) a less dovish Fed, (4) historically low volatility, and extreme overbought condition creates an environment ripe for a correction. With the likelihood of a recession so low and our positive fundamental core thesis in place, it isn’t whether we should be aggressive on any meaningful weakness, but when.”
RBC Big Picture (Charlie McElligott) – DATA AND TRUMP KICKING-UP ‘ANIMAL SPIRITS,’ AGAINST SIGNS OF Y.E. GROSS-DOWNS
–good commentary from Charlie at RBC:
OVERNIGHT: Generally higher equities (Estoxx / DAX still holding at highs while Spooz dip ‘red’—highlighting the ‘relative value’ of EU equities against US as they break-out, see Mark Orsley’s piece today) and bonds (bull flattening, with US1 +0.4% vs TY1 +0.2%), with lower rates dragging USD lower against most of G10 and especially against EMFX (20 of 24 EM currencies higher against Dollar).
The pause in the rates trajectory continues to be extraordinarily ‘tame,’ as many have been anticipating a sharper ‘counter-trend rally’ which has yet to occur. One thought here is the ongoing situation with Chinese outflows, with data overnight showing their FX reserves dropping the most in 10 months…as such we see the Yuan at 8 year lows against the Dollar. The rhetoric and twitter-barbs from Trump regarding the potential to paint China as a currency manipulator, along with the Taiwan phone-call faux paus, continue to agitate the situation.
It is certainly reasonable to believe that this source of UST selling will continue to keep USTS rallies ‘limp,’ and still in front of a very pro-growth / reflationary Trump policy mix to come: lower corporate and individual taxes, industry deregulation, trade policy (tariffs will drive up domestic prices as cheaper international goods competition is removed) and a fiscal policy shift away from monetary policy will all conspire to take rates higher in the year + window ahead.
COMMENTARY: I’ll keep this simple…we continue to see obvious re-risking in the form of “buy everything” price-action, as investors push further out onto the risk curve against a shift away from the 5+ year narrative of “secular stagnation” towards positioning that allows capture of “reflation animal spirits.
Add-in the market ‘comfort’ of knowing that both the BoJ (Iwata reiterating that they can accelerate / expand purchases overnight) and the ECB (extension expectations tomorrow) will continue providing a QE-monetary policy “backstop” to keep the grind higher in rates from getting ‘disorderly’ in the medium-term. This is critical to avoiding ‘VaR shocks,’ as well as avoiding a drag to the broad economy through ‘financial tightening.’
More of the same “price is news” on reflation positioning-pivot—a look at market metrics:
–USD 5Y5Y inflation swaps making 2-year highs last week and holding
–UST 5Y Zero coupon inflation yields at 26-month highs last week and holding
–UST 30Y Breakeven yields at 26-month highs last week and holding
–WTI Crude 17-month highs this week and holding
–XLF/XLU ratio at 8-year highs
–Global Cyclicals to Defensives index ratio at 2-year highs
–IWM/TLT ratio at 3-year highs
–U.S. Growth / Value ETF ratio at 2.5-year lows
And to the macro data-points (note: much of this is expressed in the charts section below):
–G10 Economic Surprise Index at 3-year highs
–US Consumer Confidence printing at 9-year highs
–CEO Confidence Index 3rd highest print since July 2007
–Global Manufacturing PMI’s at 27-month highs
–Global Services PMI’s at 1-year highs
–49-month highs in G10 Inflation Surprise Index
As such, we are seeing ‘real money’ client portfolio rotation stay ‘front-footed’ on adding risk. That said, and for a multitude of reasons, we are also seeing signs of tactical profit-taking into year-end from some of the leveraged-fund universe—where the performance (or outright ‘survival’) focus has been well-documented. The desire there is to ‘lock’ gains, survive and advance into next year. Thus, some evidence of ‘grossing down’ behavior continues in pockets, as shorts outperform while a smattering of ‘winning’ longs are sold.
CROSS-ASSET RISK THERMOMETER: Moving ‘right and up’ on the risk-curve.
EQUITIES THEMATIC—SAME AS IT EVER WAS: Small Cap / High Beta / Cyclicals / Value / High Short Interest / Inflation / Domestic Exposure / Weak Balance Sheet over Low Vol / Defensives / Anti-Beta / Growth / Quality / Strong Balance Sheet.
EQUITY FACTORS—IF IT AIN’T BROKE, DON’T FIX IT: Size (long small cap over short large cap) and Value (long value, short growth) continue to crush it, while momentum / quality / anti-beta hammered as per the ‘cyclical reflation’ regime.
PERCENTAGE RETURNS ON REFLATIONARY ‘CYCLICAL BETA’ EQUITIES PROXIES AGAINST ‘LOW VOL’ DEFENSIVES SINCE EARLY SUMMER TELL THE STORY:Must…have…gearing.
Small caps set to benefit more under Trump administration
tax rate the key driver (and lack of foreign revenue)
IWM’s “have become a show me story. The main DRIVER supporting small cap is Economic Indicators & Policy, as small tends to lead when real US GDP is 2-3% range. Small caps also benefit from protectionism due to lower international exposure (19% of revenues in the R2000 vs. 31% for the S&P 500) and the pursuit of a lower corporate tax rate in Washington (we estimate the R2000’s effective tax rate is 32% vs. 26% for the S&P). The small/large trade has also been positively correlated with interest rates since the Financial Crisis, meaning further increases in yields are likely to be accompanied by small cap outperformance. Retail Money Flows initially favored small cap post-Election, with inflows returning, but have started to trend positive for large again in the latest ICI update (we are watching trends here closely). Importantly, Valuations no longer support small over large, as our model is nearly back to neutral (though not expensive yet). On Investor Sentiment, a higher VIX should not derail small cap outperformance for the year as a whole, as long as the average for the year remains subdued (i.e. <25).
Second, the potential for softer regulation and non-enforcement may make accretive acquisitions increasingly difficult due to fewer projects being built, even for platforms with strong ROFO lists. Third, we believe slowing growth expectations would likely de-risk Street expectations and provide support for these names.
We continue to highlight HASI as a top pick given management’s history of managing through cycles and maintaining investment flexibility across multiple asset classes. We continue to be constructive on CAFD and NEP given their access to projects to support growth and PEGI given relatively attractive valuation.”
Small caps saw the most PE expansion since April ‘09
In November, the forward PE for small caps hit a 20-month high, jumping nearly two multiple points to 18.4x from 16.6x as the Russell 2000 rallied 11%. This was the biggest monthly rise since April 2009 and more than double the multiple expansion of any other size segment during November. As a result, small caps now trade at a double digit premium to their historical median since 1985 across all of the five valuation metrics we track, led by PE to growth at a 60% premium. The current PE is 21% above its historical median of 15.2x since 1985, and near the cycle-high of 19.1x in 2014. Overall, valuations across size segments expanded in November as all size segments posted gains for the month.
Small caps now trade above their historical premium to large. Based on forward PE, small caps went from trading in-line to large caps to trading at a 9% premium in November, higher than the historical 7% median premium since 1985 (for the first time since mid-2015) but well below the most recent 30% peak in 2011.