Tuesday, May 1, 2007

The Bubble Machine of Liquidity and Leverage

As someone who has conducted numerous hedge fund/alternative investment seminars over the past four years, I found yesterday’s front page article in the Wall Street Journal on leverage (“As Funds Leverage Up,
Fears of Reckoning Rise”) to be of great interest and a must read for all investors. Understanding the role leverage is playing on asset values and the actors involved is vital to a clear understanding of the real drivers of higher market values.

The issue of leverage was also succinctly addressed in my March 5, 2007 weekly report by the father of the Modern Portfolio Theory, Harry Markowitz:

“The unlevered investor cannot go any further than point (0,0), at which his return is maximized. If an unlevered investor tries to compete with a levered investor for returns, he can only access higher yielding, risky securities. As a consequence, the presence of leverage for some investors drives down the risk premium for ALL securities, including the riskiest securities with worse risk-reward profiles.”

As for liquidity, astute investors know that the global money supply growth shows no signs of abating. What is less appreciated is the role hedge funds are playing in the manufacturing of money. Here, Rich Bernstein’s comments on April 25, 2007 are most insightful:

“As we first wrote more than a year ago, the Fed and other central banks will effectively have to disintermediate hedge funds to curb inflation pressures. The unbridled credit creation outside the traditional banking system (i.e., from hedge funds, CDOs, CDSs, and the like) remains the key factor within the financial markets today. Monetarists, of whom we assume most central bankers are, would argue that the route to inflation is through credit creation. Inflation expectations, as measured by TIPs spreads, have been rising for five months. A manager at one of the world's largest hedge funds recently commented to us, "We aren't a hedge fund anymore, we're a bank." That is exactly our point. Interest rates may necessarily have to rise enough to disintermediate these new "banks" in order to slow credit creation.”

Investment Strategy Implications

Investors who insist that this bull market is all about earnings or some Goldilocks economic scenario are sorely mistaken. Granted, bull markets are a reflection of the real economy and earnings growth and profitability are a key component. As is low interest rates. But the lifeblood of this or any other bull market is liquidity. And when combined with leverage and the “genius” of financial engineering, capital is virtually unlimited.

As Milton Friedman would note, however, the problem develops when too much capital chases too few goods. In the real economy, capital is more than adequate. And certain economies (emerging markets) are threatening to overheat. In the financial economy, the sustained reduction in equity via M&A and buybacks is tilting the demand/supply equation strongly in the direction of over inflationing financial assets.

A valuable Greek expression sums it up, “All things in moderation.” However, moderation is the last attribute one equates with excess amounts of capital.

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