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Hedge Funds on the Next Downturn – Take Your Gains and Build Cash

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The bull market since March 2009 lows continues and has entered into its 9th year. May 2017 marked the 98th month of this bull market (surpassing the 94-month mark on the 1990 to 1998 bull market). S&P 500 gained 250+% since March 2009 while Nasdaq Composite gained 350+% and Nasdaq 100 has gained 400+%. While the overall pro-business environment established by the Trump administration has reignited animal spirits in the market, compelling arguments are being made by renowned investors in the hedge fund world. Below is a compilation of excerpts from hedge fund letters and commentaries (paraphrased excerpts).

Greenlight Capital (David Einhorn) 4Q16 & 1Q17 Letters

“Ultimately, wage inflation could become a drag on corporate profitability and higher inflation may force the Fed to raise rates substantially, potentially causing the next recession”
“We believe the case for gold is broader: greater economic, geopolitical and policy uncertainties, much wider budget deficits, and the possibility of an inflation problem all support gold”
“Difficult period to be short the bubble basket, and Tesla in particular. Perhaps as the prospects for tax reform have dimmed, the market has regained enthusiasm for profitless companies that aren’t at risk of paying taxes. A number of these stocks are back in full-blown momentum mode. Analysts continue to raise “target prices” which the market treats as news. The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before. It’s painful for the shorts, as the TSLA CEO has been happy to remind everyone via Twitter. There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen. Notably, a number of bubble stocks advanced despite missed expectations and/or falling estimates… In due time, we expect these bubbles to pop”
Janus Capital – Bill Gross’ Investment Outlook, March 2017 & April 2017

“Equity markets are priced for too much hope, high yield bond markets for too much growth, and all asset prices elevated to artificial levels that only a model driven, historically biased investor would believe could lead to returns resembling the past six years, or the decades predating Lehman. High rates of growth, and the productivity that drives it, are likely distant memories from a bygone era”
“Be more concerned about the return OF your money than the return ON your money in 2017 and beyond”
Third Point (Dan Loeb) 1Q17 Letter

“We think legislative failure on tax reform could be negative in the back half of this year… There is a risk of inflation catching the Fed flat-footed, but we see this surfacing later in 2018 or 2019, if at all. Recent dampening of data in the US, particularly in consumer spending, has raised a red flag and we will know more when we see Q1 GDP. Chinese nominal GDP growth has potentially peaked, but the main event there will be the change of government this fall and so we expect a muted status quo until then”
Crescat Capital 1Q17 Letter

“By keeping interest rates on the world reserve currency too low for too long, the Federal Reserve has created speculative asset bubbles in far-reaching areas of the globe: currency and credit bubbles in China; housing bubbles in Australia and Canada; worldwide gluts in industrial commodities including fossil fuels, iron ore, and steel; US passive index and ETF investing bubbles; financial asset and net worth bubbles in the world’s major developed countries”
“The catalyst today to burst these and other asset bubbles is the Federal Reserve’s recent interest rate hikes. The Fed has already raised the Fed funds rate three times since December 2015”
The Curse of the Republican First Year: “During 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… Eisenhower (1953), Nixon (1969), Reagan (1981), and Bush (2001)”
“Current expansion phase of the business cycle is more than eight years running. According to NBER, there have been eleven business cycles in the US from 1945 to 2009. The average length is 5.8 years. The average expansion phase was 4.8 years while the average contraction was 0.9 years. The two longest running business cycles next to the current one, extended as far as a ninth year, but their demise finally occurred in 1969 and in 2001. These years coincided with the Fed raising interest rates and Richard Nixon and George W. Bush’s first years in office”
“Aggregate valuations of financial assets relative to after-tax income is more overvalued than it was in both the tech bubble and the housing bubble”
“We hold record cash and precious metals in our long-only strategy because we are genuinely bearish right now. We will continue to look for defensive and counter-cyclical ways to deploy this cash with the goal of making money in the upcoming bear market in our long-only strategy”
“We are not perma-bears by any means. We do not buy into the secular stagnation story. We buy into the idea of an imminent cyclical downturn”
Horizon Kinetics 1Q17 Commentary

“S&P 500 now trades at 23.4x trailing 12-month reported earnings. Approach preferred by many economists and chief investment strategists uses price relative to the average earnings of the prior 5 or 10 years, in order to smooth out temporary and episodic noise. By this measure, S&P 500 trades at 29x earnings, which has been exceeded only twice before in the past 130+ years: in 2000 and in 1929”
“More understandable and less arguable than P/E is market cap to GDP. At 125% of GDP as of October 2016, it was just below the level reached in early 2000 (2nd highest on record)”
Wedgewood Partners 1Q17 Letter

“The “risk” is not whether central banks will take the punch bowl away, but rather the risk that central bankers have adopted a systemic policy of monetary policy as part and parcel of central bank balance sheet expansion as a new, permanent tool of fiscal policy. If so, then maybe the party of trying to keep up with the Performance-Jones’, come what may, is just getting started. After eight remarkable bull market years, we remain skeptical”
“We remind politicians of all stripes that Mr. Market is slave to none. Presidents who point to stock market gains as confirmation of their respective “bullish” legislative agenda may well rue the day when Mr. Market goes “off message.” Furthermore, the current administration starts their term at some of the most bullish measures on record”
Greenhaven Road Capital 1Q17 Letter

“I am skeptical of the “Trump Rally.” I understand the euphoria around the potential for changes to the corporate tax code – it’s impossible to argue with the math. For profitable companies, when taxes go down, earnings go up and everyone can party on. Given the Republicans have a majority, the likelihood of reform is clearly increased. Our process of checks and balances is unwieldy and the influence of special interests has not abated with the new administration. Inertia is a powerful force, and legislation by a committee of 600+ people has the ability to stall or bastardize the magnitude of tax reform the Trump bulls are hoping for. So, I don’t believe in the foundation of the most recent leg of our bull market”
FPA Capital 1Q17 Commentary

“Total debt outstanding for Russell 2500 companies is $2.1 trillion. Every one percent rate increase would translate to over $20 billion of additional interest expense over a period of time”
“Cumulative market cap of Russell 2500 companies has grown 16% from year-end 2014 through end of first quarter of 2017 and yet the decline in net income was nearly 20% in 2016 over the past two years. Essentially, stock appreciation has come entirely from multiple expansions. 32% of the companies in the Russell 2500 had negative income in 2016”
GMO White Paper – For Whom the Bond Tolls, April 2017

“Given current elevated valuations for “safer” equities (REITs, Utilities, Telecommunication Services, Consumer Staples), their role as “safer” equities is suspect at best. Even if one believes lower rates will last a while longer, this possibility may already be priced in”
“The traditional value investor’s admonishment that “the greatest sin is to overpay for assets” becomes ever more important as the future value of assets gets harder and harder to forecast. Applying a high discount rate to cash flows that will not occur until far in the future is a rational response to heightened economic and political uncertainty and would likely be kind to value investors and harmful to growth-oriented investment styles”
Buyer Beware!
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