‘Stuff’ versus paper

“Unfortunately, self-regulation stands in relation to regulation the way self-importance stands in relation to importance..”

-  Willem Buiter, in The Financial Times, on the latest laughable attempt by banks to weasel out of any kind of real regulatory oversight.

 

“There was a time when a fool and his money were soon parted, but now it happens to everybody.”

- Adlai Stevenson.

 

Judging from admittedly unscientific anecdotal evidence, investors seem to believe that equity markets have dodged something of a bullet. And while certain sectors (leisure goods and retailers, telecoms, financial and media – the list is not exhaustive) have all slumped since the start of 2008, the FTSE 100 as a whole is holding up pretty well against its European and even North American peers – financial relativism, perhaps, always being the last refuge of the scoundrel. But just as there is more to banking than specious attempts to evade accountability, so there is more to investing than just lobbing one’s savings into the stock market. How have other major investment sectors and asset classes fared ? We can debate subjective fundamentals, after all, until the bulls come home, but the price is where the price is. As Mrs. Thatcher said, you can’t buck the market. (And as Hank Paulson and Ben Bernanke are now discovering, you can’t market the buck.)

 

As at the end of the first quarter, the FTSE 100 index was showing a total return of -10.3%. This compares with -9.4% for the S&P 500, and with an altogether more miserable -15.6% for the FTSEurofirst 300. The Nikkei 225 was showing a total return of -17.5%, the Hang Seng an almost identical -17.4%, and Shanghai a somewhat more striking -34%. Whatever the Chinese economy is doing, in other words, its stock market hasn’t exactly decoupled from the west – more like entered a suicide pact.

 

So much for stocks. If you liked them in January, you have to love them now. As to those certificates of confiscation known as government bonds: UK Gilts, as represented by the FTSE Actuaries UK Gilts All Stocks index, have returned 0.19%. After inflation, of course, that is a loss. Bloomberg’s US Government Bond Index has delivered a total return of 4.49%. Whether that represents a meaningful real return largely depends on whether you trust US inflation data. Euro zone government bonds were almost exactly in the middle, with a return of 2.29%. As we never tire of writing, the optimal risk / reward – if there is any value inherent in government debt – is likely to be in the inflation-linked market.

 

Hedge funds, often erroneously referred to as an asset class (talent class might be more appropriate, only the phrase smacks of leaden irony given 2008’s returns), have disappointed. The CSFB / Tremont Hedge Index, as at end March, was showing year-to-date returns of -2.01% (not bad considering the stock market, but uninspiring given the essential mission to generate absolute returns in all market environments). Whether hedge fund investors are waving or drowning will be almost entirely down to strategy selection. The “traditional” strategies – convertible arbitrage (-7.6%), event driven (-3.3%), equity long/short (-4.1%) – were largely rubbish. A degree of honour was restored by dedicated short bias (+9.8% - every dog has his day), global macro (+6.9%) and managed futures (+10.4%). One does feel obliged to ask, however, whether hedge funds as a whole have just been hit by their quadrans horribilis – as FRM’s John Beech points out,

 

“The worst fear for many in the hedge fund industry has always been a bankruptcy in the prime brokerage community, and.. the threat posed by the run on Bear Stearns intensified the deleveraging process that has been occurring in one shape or form since the summer of 2007. As Bear Stearns was an important counterparty to many Fixed Income Arbitrage hedge funds, the link to losses in this sector is clear.”

 

John Beech attributes most hedge fund losses during the quarter to risk aversion trades: deleveraging, de-risking, and hedging. Hope should obviously play no role in the investment process, but it may not be inappropriate to suspect that if the hedge fund sector can weather the volatility of Q1 2008 largely unscathed, the survivors of the deleveraging cycle may be well placed to benefit from the resumption of slightly more normal market conditions. While hedge funds are supposed to benefit from volatility, you can evidently have too much of a good thing. A final aside: “multi-strategy” delivered -3.9% for the quarter. Fund of funds managers will have to work hard at regaining the trust of investors newly sceptical of their ability to locate alpha as opposed merely to creaming off fees.

 

No surprises to see the asset class winner in the first quarter’s lottery of returns: commodities. The Dow Jones AIG Commodity Index returned 9% to end March 2008. Oil itself (WTI crude for May delivery) returned 7.3%; wheat 4%; natural gas a stunning 32.7%; gold 10%. And perhaps there is more agreement here than in most sectors that commodities prices now seem to be ensnared in an uncontrollable bubble. ‘Bubble’, of course, is also how investors describe rapidly appreciating assets when they’re not themselves already on board.

 

In light of the widespread losses incurred by most asset classes so far this year and the seemingly crowded trade that is pretty much every component within the commodities complex, what are investors to do ?

 

At the risk of stating the blindingly obvious, perhaps the most critical observation is to restate the fundamental counsel: only invest what you can afford to lose. Bound up within this core advice is the requirement to identify an appropriate time horizon for investment. An unrealised loss from a quality equity investment, for example, may be nothing more than a reflection of market noise. But if the capital tied up in that investment is soon required to set against short term liabilities, something has gone awry with the investment process.

 

And while the price chart is the purest form of investment intelligence, the role played by so many ‘shadow banking institutions’, leveraged, deleveraging or otherwise, is likely to keep prices across multiple sectors highly volatile. Given the vulnerability of equity markets to fresh disappointments by ostensibly internationally diversified businesses, and the particular vulnerability of Anglo-Saxon asset markets to a still deteriorating residential property sector, there seems more than usual merit in a) a healthy exposure to cash, and b) a disciplined commitment to dollar cost averaging versus market timing. As to preferred equity market sectors, we have long advanced our preference for energy, natural resources and related support services. As we have now had confirmation from no less a business than Rio Tinto that world quality miners are unable to maintain production even with commodities prices at record highs, that commitment is – US recession or not – highly unlikely to change now.