The crowds, momentum, and risk in markets

 "These heroes of finance are like beads on a string - when one slips off, all the rest follow." - Henrik Ibsen during the early phase of the Great Depression 

An insightful comment from someone not in finance. Ibsen was mainly a playwright; however, he was aware of the goings-on in Europe and the world. We have heroes of finance, but they are not the contrarians. They are the ones leading the crowd or banging the drum to move the crowd. Everyone likes the person who reflects their thinking. I follow Bob because Bob's thinking is consistent with my view of the world. Show me the person who is thinking differently. They are the people who will move me to think better. 

Global Capitalism - we may never go back the the early 20th century world

 

Jeffry Friedman is one of the leading economists on the history of the international global order. His book, Global Capitalism: Its Fall and Rise in the Twentieth Century, is now 20 years old, but it is a good read if you would like to know where we have been before the current globalization upheaval. Global capitalism is not natural. It was fought for by a few visionary bankers. These bankers made money, but they also saw a more connected world. Unfortunately, the Great War destroyed the high point in global trade and reset the world financial order. The depression forced new isolation. The Second World War again led to a new, more controlled international order under U.S. dollar hegemony. This system broke down, but we saw a new emergence of global capitalism following the fall of communism, cheap transportation, and a world willing to cooperate. The story ends before the Great Financial Crisis, which again led to a shift in global capitalism toward autarky, neo-mercantilism, and non-cooperation. We are observing a decline in trade volumes. We may never see coordinated global capitalism, but we do see bastardized forms of public-private coordination imposed on economies. 

Hedge funds taking on long equity exposure

Hedge fund strategies are often purchased because there are expectations that they will exhibit a beta similar to that of equity markets. Not all the betas will be the same, but they will generally run between .5 and .6 on the high side to zero or slightly negative on the low side. CTAs usually have the lowest beta but also likely have low alpha. 

These betas or correlations will change with market conditions. The hope is that if there is an increase in beta, it is not because hedge fund managers are chasing the equity market with momentum trades, but rather because they are showing some market-timing skill. Evidence on market-timing the overall market is weak, so there should be concern when hedge funds exhibit higher short-run correlations with equity markets. Of course, hedge fund managers may have timing skills, but this is not the reason why most managers are buying these strategies. 

Investors seek uncorrelated returns, so there is a general expectation that betas will be low and stable. Yes, that means that hedge funds will underperform versus the overall market on an absolute basis, but investors should not pay for unwanted beta.

 

The K-shaped economy - Wall Street versus Main Street

 

I normally hate the comments about the difference between Main Street and Wall Street. Usually, it is a false dichotomy, but the current environment suggests that the average consumer or wage-earner is having a harder time than wealth-holders. This is what happens when we are in a more inflationary environment. Yes, inflation is off its highs, but the average inflation for this century is closer to 4% than the 2% Fed target. 

The labor markets are looking weak and confidence is weak, yet the stock market is higher based on strong earnings from those economies that have network effects and represent the tech industry. Two-income households may be doing well, but the rest of the country is trying to hang on and deal with recurring price increases that do not appear in the CPI indexes. 

A strong stock market may pull the economy higher, but that is unlikely. The higher stock market is likely the result of too much money chasing existing assets. The good markets may not be seeing all of the inflation, but the financial markets are seeing "asset inflation.