Louis Gave is a principal of Gaveco, a London-based independent investment strategy service formed a couple of years back by his senior partner and father. Not so remarkable, perhaps, except that Charles Gave, for all his fierce independence, has long been recognized as a leading – and original light in the world of European investment management.
A successful strategist who more than proved his mettle in big-time fund management, but who chafed at organizational strictures as much as at early retirement, Gave then went back to performing economic and asset allocation advisory services for select institutional clients a couple of years back. I caught up with Louis recently (Charles was touring Cambodia) for an update on the Gaveian world view.
Last time we talked, Louis, you were just undertaking a big study about the impact of hedge funds on the stock market-
I'm still putting the finishing touches on it. But here are just a couple of facts. Already, today, in Europe, 60 percent of commissions are generated by hedge funds.
More than half?
That's right. Even though, at the same time there are basically only 300-400 European stocks with enough volume for the hedge funds to trade. The implications are clear, in terms of concentration of ownership and also in terms of volatility. My work shows that the volatility of European large caps has been increasing massively over the past four or five years, while the volatility of the mid-caps and small-caps has actually been falling. And there's no reason to think that the impact has been any different in the U.S. Whether you look at the 300 or 500 largest-cap stocks in the U.S., or at the Dow Jones Industrial Average, volatility there has also been going up quite substantially since 1996, while volatility on the mid-caps and the small-caps has actually gone down. The question I ask is, since there's more volatility now in the big stocks than there is in small stocks, which is the exact opposite of the way it used to be in the early '90s, does this also mean that we should be seeing larger risk premiums attached to the big stocks now, much as they were attached to the smaller caps back then?
What's your answer?
It should. And if they do get a higher risk premium, that will present a problem for the bull market that we have been living, which has very much been a bull market of big cap stocks. And which, in a sort of virtuous circle, made possible a hugely active mergers and acquisitions market. A company like Cisco could buy another company every two weeks-
Because it could use its inflated currency-
Thanks to its market cap, thanks to its valuation. Because when you're trading at 80 times earnings, it makes sense to buy anybody in town who's trading at only a 20 P/E, because it is immediately accretive to earnings. But now, if you start to see bigger risk premiums attached to the big cap stocks than to the smaller caps, that sort of opportunity will disappear, and that will kill the M&A market here, much as it has in the U.S. If all of the big companies start selling at 16 times, they are not going to start lining up to buy small-cap companies that trade at 20 times.
God forbid, dilution.
So among the first big victims of this trend, I think, will be the venture capital firms-
Already reeling from the slamming shut of the IPO window-
Because the other big exit strategy they've depended on is M&A. You know, it used to be that you created some silly switch company and sold it to Cisco for paper, which you converted to real money as soon as you could. But now not only has the value of the Cisco paper you are still holding gone way down, it's no longer providing an exit for the VC companies. So you can count not only M&A bankers but VC companies among the first victims of the hedge fund craze here.
Everything you're saying about the European market would apply to the U.S. in spades, since the hedge fund movement is even more firmly established here.
Oh, for sure. The other issue, with the proliferation of hedge funds, is that there are basically only two types, the long/short funds and the arbitrage guys. And there's only so much arbitrage to do in any market. With more and more money piling in, at some point, the returns won't be there. They may be getting a stay of execution, because it is cheaper and cheaper for them to get leveraged, as interest rates fall. But at some point, the returns are just not there. The arbitrage guys, as you know, work to make the market perfect. What's more, what happens when rates start rising? Anyway, where I am coming down in my paper is that this massive increase in hedge funds ultimately might not be terribly bullish for the big cap indices.
Even though big caps tend to be what the hedgies favor?
Yes, because if all the money in the world starts moving towards either indexing or absolute return mandates, which is what we are seeing, then the small-caps will fall by the wayside-and accumulate tremendous value, while becoming anything but volatile.
The only problem is, no one will care about that value.'
That's true. That's a very, very good point. I guess it depends what your horizon is. If you're a smart institution with a horizon of 10 years, and want stable returns, you'll find them in small caps.
Back up for a second, Louis. Why should anyone care what Gaveco thinks?
We're basically a small research shop focusing on economics for institutional asset allocation. There was, of course, that famous study by Ibbotson that said 90 percent of portfolio returns come from asset allocation, not stock picking. And our research into the economy and liquidity is geared to trying to find markets and sectors that are going to outperform.
And your advice has so far proven infallible?
Oh, God, no. We wrote our clients in mid-February, telling them that on all our indications, the liquidity crisis – which had been brought on by the Fed's tightening, by rising oil prices, by a very strong rate of economic growth – would be over by the beginning of the second quarter. So you want to be fully invested by the beginning of the second quarter. There was a good rally in April, so we're feeling quite smug. May was decent, and then June, July, August were just horrible. September, obviously, was awful beyond description. But even before the attack, we'd started looking for what we were missing.
Which was?
Something we'd never seen before. On the one hand, you've had our primary liquidity indicator, which monitors the liquidity pumped in by central banks, going through the roof this year. It was two standard deviations up, higher than we've ever seen, because of the just-massive liquidity infusions from the central banks. That's why the markets rallied in the spring, and why we expected the rally to continue. We'd never seen such an influx of liquidity fail to do anything for the system. But at the same time, our market liquidity indicator, which had improved in April, in May, and a very little bit in June, just absolutely collapsed in July, August and September. And it is now at a maximum negative reading.
What does your market liquidity indicator measure?
It takes into account corporate spreads, quality spreads and the performance of banks. We basically try to measure the amount of intermediation going on in the market. One of our big surprises has been the fact that banks have not done well at all in the past three to four months. You'd expect, with the yield curve as steep as it is today, and corporate spreads as wide as they are, banks to be minting money. If you can borrow at three percent from the Fed, to buy yourself a AAA bond yielding 8.5 percent, you ought to be doing it till the cows come home. Even if you're risk averse and just buy a government, it is yielding 4.6 percent and you're still making money.
Unless you have all sorts of problem loans and such that you haven't properly reserved against.
Exactly. As I see it, there are only two explanations for the divergence we're seeing in our liquidity indicators. Either the cash has reached the banks only to be plowed into provisions against a lot of bad loans-basically, Keynes' liquidity trap, which is more or less what happened in Japan after 1996-
And you doubt the banks are bust?
Well, when that's the case, the markets typically get a whiff of it coming and the bank stocks start massively underperforming. You see cuts in interest rates and bank stocks falling even more. That is what you saw in Sweden and in Japan in 1990. We haven't really seen that yet, although we're starting to see some signs in Europe that have us worried. Not in the U.S., though, where the banks haven't underperformed. So there's no real concern I see that the U.S. banking system is bust. Mostly because a lot of debt is already off their balance sheets through the securitization process, they're not really exposed. In truth, the people who own all the bad debts in the system today are the guys who own all the corporate bonds and the telecom companies. It's not the banks. It's more like the pension funds and some of the mutual funds. The big liability problem we could have going forward, in fact, are underfunded pension funds.
Where's the market liquidity gone, if not into a Keynesian liquidity trap?
The second possibility is that we've seen a collapse in the velocity of money. Which is just a fancy way of saying that people have raised massively their preference for cash. That's what we think has happened. But interestingly, it hasn't been consumers who've decided to hold more cash. It's companies. They had huge inventories that weren't even recognized. People like Cisco came out a while back and said things like, "Our just in time inventory controls were b-s and we've got $3 billion in inventory to write-off." So we've gone through a massive inventory liquidation. And you can see that companies are hoarding cash by looking at what sectors have been massive underperformers in the stock market this year-they are almost all companies that sell to other companies: technology, advertising, machine tools, etc. The sectors that have massively outperformed, meanwhile, sell to the consumer: retail, construction, housing, automobiles. The consumer has held his own.
Okay, but now what?
Well, you don't raise cash forever. At some point, you've got about two years' worth of cash and you feel pretty confident. So the first question is, "When will U.S. companies be done raising cash?" The second question is, "Will the U.S. consumer start raising his cash preference because he's afraid?"
Afraid? Gee, with layoffs, anthrax, terror attacks-
Nonetheless, the latest figures for real disposable income are going through the roof, and it makes sense. If you're a U.S. consumer, almost everything you buy is going down in price. Your mortgage bill is going down. Your tax bill is going down. If you want to buy an airplane ticket or go to Disney World with your family for Christmas, that's going down in price. At the same time, your house's price is still rising because of this rise in disposal income. So you feel good, because at the end of the day, you just have more money. Then, there are two options. Either the U.S. consumer becomes more Japanese-like and saves more, or he remains American and spends it because it's burning a hole in his pocket. Historically, it's better to bet on the American acting American, than on the American acting Japanese.
So you expect the consumer to continue to carry the economy?
Let's put it this way. We're at a point today where consumer disposable income is rising very strongly. At the same time, inventories are at a very low point. Those ingredients could produce a sharp snapback in growth as soon as companies realize, hey, the demand is there. Boom. Off we go again. Either production snaps back to the level of consumption, and we get a V. Or consumption plummets for the psychological reasons and we get an L. But we are betting on a V, as long as you have rising home prices, falling oil prices, taxes and mortgage rates.
Which is why your favorite market sectors aren't at all defensive?
The consumer staples don't work at all here. Although everywhere we went in the U.S. recently, people were saying "It's time to hunker down. Buy foods, buy pharmaceuticals, buy utilities." But that's precisely wrong because the disposable income isn't rising because of higher wages, it's rising because of falling prices – something we haven't seen since the 19th Century. This is what deflationary booms are made of. A good's price falls by say 10 percent, and demand for it increases by 25 percent. A typical example has been cell phones. When cell phones fell in price by 50 percent, demand didn't increase by 50 percent. It increased by 300 percent. Yet today, everybody's telling you to buy coffee and buy utilities. If the price of electricity falls 10 percent, you're not going to use twice as much in your house. If the price of coffee falls 10 percent, you're not going to drink twice as much. However, if the price of a flat screen TV falls 20 percent before Christmas, that may boost demand by some multiple of that. This is what we saw with PCs. This is what we saw with mobile phones. So the real questions are what goods have a strong elasticity to price or to revenue? I think you want to be exposed to sectors that benefit from both those trends – and those tend to be pretty cyclical, like consumer electronics and travel.
What signs are you looking for to confirm your optimism?
First, an indication that liquidity is coming back to the market, which should be outperformance by the bank stocks, followed by outperformance by the investment banks, which are the biggest financial intermediaries out there. Second, we should see a narrowing of corporate bond spreads. As companies stop raising their preference for cash, the first thing they should do is buy-back their corporate bonds. If you have cash in the bank today and you're a AAA company, you can buy your bonds back for 85 cents on the dollar. Which is 15 cents you can book as a profit. So in one stroke, you boost your EPS and better your balance sheet. And as companies do that, corporate spreads should narrow.
Suppose you're wrong, and the U.S. economy is headed for an L?
That's where our global asset allocation recomendations come in. As we look at Europe and the U.S., both stock markets are basically priced for a rebound in growth. Asia by contrast, has known 10 years of bust. And Asian markets are essentially priced for another 10 years of bust. So the best asset allocation today for a money manager might to be to overweight Asia and Japan, because over there, they're priced for a bust. So if they do end up having another ten miserable years, at least that's in the price you paid. And if Asia and Japan rebound, well, that should be a very profitable surprise. On the other hand, at current prices, even if the U.S. and Europe do rebound as expected, well, a lot of that rebound is already in those prices.
Is your money where your mouth is?
Yes. Today our own money is about 55 percent in Asian equities. The risk/reward profile is just so much greater there than anywhere else today.
Are you in red chips or more time-tested markets?
In truth, we're in pretty much everything. We're in the Nikkei. We're in the Jasdaq. We're in Hong Kong. We're in Singapore. We're a bit in China. We're in Taiwan and we're in Korea. But we're not in the secondary markets, like Malaysia, or Thailand.
Thanks, Louis.
Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co. L.P., Greenwich, Conn. http://welling.weedenco.com
