Stuck in the Middle

“Well I don’t know why I came here tonight

I got a feeling that something ain’t right

I’m so scared in case I fall off my chair

And I’m wondering how I’ll get down those stairs

Clowns to the left of me, jokers to the right

Here I am..”

– ‘Stuck in the Middle with You’ by Stealer’s Wheel; also the soundtrack to the notorious ear-removal sequence in Quentin Tarantino’s ‘Reservoir Dogs’.

There has never been any shortage of clowns and jokers in the investment markets, but it sometimes takes a bear market to flush a few out. In contradiction to the widespread fear that hedge funds would precipitate the Next Big Crash, we now know that it was actually the banks that laid its (wobbly) foundations. Now, with sentiment fragile and fund managers widely sheltering in cash, the journalists are having a go at pushing at the pedestal. “RBS issues global stock and credit crash alert,” warned Ambrose Evans-Pritchard of the Telegraph, inviting “one of the worst bear markets over the last century”. The RBS research note in question was more subtly entitled “Crude-flation Concerns Spike”; while crude-flation is undoubtedly an uglier word even than stagflation, it is not clear who Spike is, nor why he should be concerned. It is certainly difficult to know quite how worked up (if at all) to get about the RBS note in question. Some of us evidently felt that the markets had already “crashed” in the conventional sense of the word, given the falls in credit markets and stocks – particularly banking stocks like, say, those of RBS (-60%) – since the summer of 2007. “The very nasty period is soon to be upon us – be prepared,” warned RBS on 11th June (2008). The market environment is nasty already, and has been for quite some time, as anybody with any form of investments will surely testify. Perhaps future research will report the sad passing of Queen Victoria or the sinking of the SS Titanic. But it is always nice to hear that the banks who brought us the credit crunch in the first place are bang up with events. Just after they’ve had their latest emergency rights issue.

There is, of course, a long and inglorious history of commentators calling for a Crash. Perhaps the most piquant example is that of Elaine Garzarelli, the stock analyst who became associated in the public’s mind – no doubt thanks to the press – with “predicting” the 1987 stock market “correction”. As Michael Lewis of Bloomberg pointed out in 1997, thanks to the marvel of modern technology it is now easier to keep tabs on the prognosticators and less easy for them to squirm away in a cloud of over-hedged obfuscation. Access to a Bloomberg terminal “illustrates among other things the sheer lunacy of anyone who would bet money on anything Elaine Garzarelli said:

“Aug 5, 1996: Garzarelli Sees Market Rise as Selling Opportunity

Oct 8, 1996: Garzarelli More Pessimistic on Direction of Stock Market

Oct 26, 1996: Garzarelli Sees US Stocks Falling up to 20%, Magazine Says..”

And a mere few years after she was regarded as a stock market genius, the cruel headline:

Elaine Garzarelli Denies She’s a Contrary Indicator”

Good luck to the analyst who insists on feeding the media with constant “forecasts” of market direction. The beast is insatiable, though, and it can turn from fawning puppy to slavering rottweiler in less time than it takes to look up how to spell Teun Draaisma.

And yet there are reasons to be cheerful (or at least not full-bloodedly crazy ape apocalyptic) on the basis of the latest Merrill Lynch fund managers survey. A net 27% of fund managers were underweight in equities relative to other instruments of confiscation. A net 42% of managers were overweight cash, up by 10% from May. Karen Olney, chief European equities strategist at Merrill, was quoted by the Financial Times as saying that

“Investors don’t know where to go. They are favouring oil and commodities plays in equity markets, which shows that inflation is playing havoc with the rest of the economy.”

At PFP, we are quite happy telling investors where to go. On second thoughts, there may be better ways of expressing that sentiment. But the investment approach that makes the broadest sense to us is simply to remove one’s dependency on (still volatile and still largely vulnerable) equities and (extraordinarily unattractive) bonds, and to raise one’s exposure to absolute return funds and real assets, subject to the vagaries of relative valuation. By absolute return funds, we mean diversified hedge funds as opposed to warmed over and reinvented bond funds travelling under the guise of something useful but happening to charge higher fees. As the marketing departments of big investment houses know well by now, there is a danger of being entirely out of the stock market, in that the single best days of market performance account for huge portions of the market’s overall return for any period. And you have to be in it to win it. But by the same token, there is absolutely no requirement to be invested in rubbish (bank stocks; retailers; homebuilders; businesses exposed to the bowel-shattering horror show that is the Anglo-Saxon middle market consumer), and there are still plenty of reasons to be invested in high quality businesses associated with energy, energy support services and infrastructure, not least because they’re about the only remaining equity assets still rising in price. That makes them sound like momentum plays. Which they are, to a degree – but the likely period of that outperformance and momentum is a matter of years, rather than days or weeks.

The other lingering scent of good news hangs sweetly in the form of Japan. CLSA’s Jolyon Montague quotes Sir John Templeton: bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. Japanese stock markets seems to have moved, finally, from the pessimism to the skepticism stage. And as Asian hedge fund specialists Stratton Street point out, the relative performance of equity markets in Q1 and Q2 in local market terms is striking:

Market Q1 Q2

Japan -17.80 +13.4

Hong Kong -17.85 -0.2

China -24.09 -28.4

India -22.88 -3.6

Australia -15.52 +0.2

Korea -10.18 +2.1

US -9.92 +1.1

Germany -18.99 +3.1

We were perhaps a little harsh on RBS: yes, it is an absolutely ugly investment environment. Some of us realised that, and articulated our fears, months ago. But we are convinced that selective opportunities remain, even in equity markets, if not in bonds. And as the Sage of Omaha has it, one good time to be greedy is when others are fearful.

Originally published at The Price of Everything and reproduced here with the author’s permission.