Why are hedge fund titans so upset about the stock market boom?

May 9, 2013

We can argue all day long about whether quantitative easing policies from the world’s central banks are doing much to help the economy. But this much is for darn sure: It is boosting a wide range of financial markets.

The stock market is the one most often cited, including the ascent of the Dow Jones industrial average over 15,000 for the first time this week. But it’s equally true for plenty of other assets: corporate bonds, mortgage-backed securities, government bonds, real estate investment trusts. This is exactly what you would expect to happen in a world in which the Federal Reserve, Bank of England and Bank of Japan have all bought vast sums of bonds using newly created money. Indeed, pushing up asset prices is an explicit goal of those policies.

The man behind the curtain may just be a balding fellow with a beard.
The man behind the curtain may just be a balding fellow with a beard.

So, why are some of the people who you would think would be the biggest beneficiaries of this strategy so angry about it?

That was the consistent tone among titans of the hedge fund industry at the Sohn Investment Conference conference Wednesday. Fed chairman “Ben Bernanke is running the most inappropriate monetary policy in the history” of the developed world, said Stanley Druckenmiller, the onetime protege of George Soros who now manages his own billions. He was reportedly one of several speakers to argue that the rise in U.S. financial markets is somehow a giant fraud, a bubble that will inevitably pop. It's a set of arguments that is hardly confined to this conference but often heard among the financial chattering class everywhere from CNBC to the fever swamps of Zero Hedge.

Why can’t the financial elite stop worrying and learn to love this market rally?

Let's start with inflation. Many of the strongest critics of central banks' easy money policies  are convinced that we either already have, or soon will have, high inflation. Most price measures show inflation that is actually below the 2 percent that the Federal Reserve aims for, but a common view among the financial commentariat is that either those numbers are cooked or that eventually they will zoom upward and the central banks will be unable or unwilling to raise interest rates to contain it.

They could be right — we are in uncharted territory for central banks. But while joblessness and below-par economic growth are the main economic stories across the developed world, it seems like an odd time to worry so much about what seems like a distant threat. And inflation may be more troubling for wealthy investors than others; if you are a large investor, you are probably a net creditor, and thus have plenty to lose if inflation means you get paid back in less valuable dollars.

Another reason for the inflation aversion may be that many hedge funders came of age when high inflation really was a problem, and may see the ghosts that haunted them in their formative years. Similarly, Arthur Burns, the 1970s Fed chairman who allowed that inflation to take root was once described by a student as “a creature of the Great Depression,” the time in which “he was growing to professional maturity, and he saw the whole economic system disintegrate before him.” The inflation-fearers may be making the same analytical mistake in reverse.

But what about the conviction that the financial market rallies are “fake” and cannot be sustained?

There certainly are some markets in which prices don’t seem to match logic, particularly in corporate bonds. Apple Inc. last week issued 30-year bonds for a mere 3.9 percent! That suggests a market in which investors are willing to shrug off risk.

But other markets seem a lot more reasonable. Okay, so the stock market is up a lot over the last four years — the S&P 500 up 140 percent since March 9, 2009. But that is a jump from extraordinarily depressed levels. Meanwhile, corporate earnings have risen a lot in that time. So, yes, stocks are way up, but so are earnings. Indeed, by most measures, the “equity risk premium,” the extra compensation that investors are getting in exchange for taking the risk of buying stocks, is uncommonly high today. Here’s a chart by researchers at the New York Fed that calculates that premium using a variety of models. It shows that investors in stocks are getting about 5 percentage points in returns above and beyond what they would get for Treasury bonds. The last time the equity premium was near that high was the early 1980s, the start of a 25-year bull run for stocks.

Source: Federal Reserve Bank of New York Liberty Street Economics blog
Source: Federal Reserve Bank of New York Liberty Street Economics blog

Now, as the Fed researchers point out, this is not so much a function of stocks offering outlandishly high returns as a case of Treasury bonds offering exceptionally low returns, which means moderate earnings yields offered by stocks look great by comparison. If bond yields rise rapidly, suddenly stocks wouldn't look so attractive.

But here’s the thing: Whatever mispricings that hedge funders see in these markets should be causing them to exult, not to complain! You think there will be huge inflation in the years ahead? Buy inflation-protected Treasury bonds while shorting regular Treasuries!  Think that the stock market is overvalued and will collapse the minute the Fed backs away from QE? Then buy long-dated puts on the Standard & Poor's 500 index (that is, bets that the market will decline significantly in the future)!

Here's what seems to really be making the investor class so angst-ridden over easy money policies out of the central banks. Over the last few years, it has felt like the usual rules do not apply: Zero interest rates from the Fed haven’t sparked inflation; interest rates have fallen despite huge government deficits; and the stock market has risen steadily in the face of a still-weak economy.

Someone who had invested money in a diversified, passively managed mix of stocks and bonds has had a very good four years of returns. Meanwhile someone who used aggressive trading strategies may have lost a boatload of money if he or she bet wrong. When the world isn’t working the way you think it does, or should, it is mighty frustrating —all the more so when it costs you a lot of money. And it may just be more convenient to blame the (bearded) man behind the curtain as the master market manipulator than to own up to your mistakes.

Correction: An earlier version of this article said that the Sohn Investment Conference was in Las Vegas. It was in New York.

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