From the February 2009 issue of Wealth Manager Web • Subscribe!

February 1, 2009

Now What?

Anyone questioning the new market paradigm has only to look back a few months to early November 2008. Days after Barack Obama's historic presidential win, the stock market lost nearly 10% of its value--the largest two-day decline since the market crash of 1987. With the housing market continuing to drop, dismal retail sales, falling earnings, and automakers running out of cash, investors are running to the exits in droves.

Mere months earlier, every asset class appeared poised to reach new highs. Plunging commodity prices, falling bonds, and the most ferocious bear market since the Great Depression have changed all that. Investors are scared to death, and advisors have been struggling to both comfort their clients and reposition portfolios to protect capital without forfeiting too much upside should the tide turn.

Welcome to Wealth Management 2.0.

Advisors struggling to position client assets and looking to expand their business are facing some of the toughest challenges in history. But for those willing to take a strategic view of the markets, the current environment may be a foundation for outsized gains that have not been seen in decades.

In the following pages, we'll explore the prospects for the three most utilized asset classes--stocks, bonds and hedge funds--and go on to construct a game plan for
investing in this new paradigm.

Risk: A New Definition

As we go to press, the dramatic sell-off in stocks has reached historic proportions. With a peak-to-trough loss of about 52%, the current pullback in domestic equities has only been outpaced by the Great Depression, when stocks fell 86%. Even with all the losses, the question of whether stocks are at bargain-basement levels is more nuanced than it may appear.

Buyers of stocks certainly have a plethora of facts to support their position. U.S. stocks are trading at around 10-times their 2008 earnings; European bourses are a bit cheaper. After adjusting for the massive write-offs from the financial and auto sectors, profitable companies are trading at even lower levels. If stocks were to return to their historical multiple of 15-times earnings, the S&P 500 index would have to rise about 50%. This is roughly equivalent to the gain from the market's nadir in 2002 to October 2007--a five-year run that began with the blowups of WorldCom and Enron.

The current interest-rate environment should also provide some fodder for the bulls. The last time stocks traded so cheaply was in the late 1970s, a period punctuated by sky-high inflation and interest rates. At the time, government bond yields topped out at 16%. Compared to the current low-yield environment, stocks have little competition from CDs and other alternatives.

Probably the bulls' most compelling argument is the likely timing of the recovery. Currently at 12 months, this recession is longer than any average 10-month economic pullback since the 1940s. The record for the longest recession is 16 months--reached during the periods from '73 to '75 and '81 to '82. That length would put the bottom of the current recession at the end of the first quarter. Since equities tend to rally before recessions end, this would put the bottom for stocks even sooner.

After bear markets, stocks typically rally strongly. According to a recent Citibank study, stocks are poised for a huge rally over the next 12 months based on current record-low bond yields and modest P/E ratios. Furthermore, the average 12-month return of the S&P 500 after a bear market is an impressive 42%, even when metrics are not as attractive as they are today.

So what about the bear side of the argument? Based on the above logic, stocks certainly appear to be cheap. But as PIMCO's Bill Gross stated in his December 2008 "Outlook," the equities market is facing a new reality of more regulation, lower leverage, and higher taxes: "One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government, and that a near proportionate share of profits will flow in that direction as well." In his view, these headwinds lessen much of the bulls' argument

And then there are hedge funds. With equity prices crumbling and commodities ending their long bull run with a huge sell-off, hedge fund returns for 2008 will be among the worst on record. Although there is a scant $1.7 trillion in such funds (compared to $26 trillion in mutual funds), hedge funds are levered vehicles that hold considerable sway in the capital markets. But as investors fled alternatives, hedge fund managers have been forced to sell assets--many at fire-sale prices. This has only served to exacerbate the decline in equity prices.

And hedge fund liquidations are far from complete. An estimated $250 billion of leveraged fund-of-fund structures and structured product deals have been created with $100 billion still outstanding. Losses from hedge funds have caused most of these structures to liquidate. As a result, many funds have gone to cash. But those that could not due to investments in illiquid securities have erected gates to prevent further client redemptions. Panicked investors responded by heading for the exits for other, more liquid funds--some of which have actually performed well during the last few months. But the shrinkage in the hedge fund industry has effectively taken a large natural buyer of stocks out of the game--at least temporarily.

Pension funds and insurance companies have also run into trouble. With a combined $50 trillion in assets, these big players have been hurt even though their equity exposures are modest. During periods of losing valuations, pensions and insurers are required to reduce risk to preserve capital. As a result, they are forced to reduce positions even as valuations continue falling.

That leaves mutual funds and individuals as the likely bottom-fishers for stocks. These groups have plenty of purchasing power, but with hedge funds, pensions, and insurers unable to participate in the early stages of a recovery, bears contend that any rally will lack the panache of a full-scale buying spree.

The L-Shaped Recovery

The lack of large buyers in the equity markets has created a new definition of risk: the dreaded "L-shaped" recovery. As leverage worldwide ratchets down, and the largest market participants are forced to sit on the sidelines until volatility subsides, the market may simply meander around.

The saving grace for this market is the unprecedented degree of unadulterated, panicked selling that has taken down the price of stocks of all companies--not just the bad ones. After falling 50% in 12 short months, and with most indices showing losses over the last decade, students of both financial history and economists heartily agree that valuations have not been this low since the bear market of '72 to '74. By sifting through the rubble, investors with a keen eye and lots of patience should make a significant return in the next few years.

Investors will be looking for as safe an equity investment as possible, and that's likely to mean that domestic stocks will be the first to bounce. Although small-cap issues tend to do better early in an economic cycle, larger capitalization issues may be preferred to avoid increased bankruptcy rates.

Credit Conundrum

If it seems odd to include the fixed-income markets in an article about potential investments, it certainly should. After all, credit is what brought the markets to their knees in the first place. But compared to the Gordian knot of equities, the opportunities in fixed income are so ridiculously tempting that few detractors even exist.

The conditions that led to paltry valuations in the investment-grade corporate debt market have been well documented in the press. Low interest rates in the early 2000s led to an increase in the subprime mortgage sector which grew much faster than more traditional mortgages. Federally-backed Fannie Mae and Freddie Mac lowered their standards to compete with publicly owned firms. As a result, the percentage of mortgages in the subprime sector rose from about 3% of all mortgages in 2002 to more than 15% in 2006. Easy credit and lax lending standards led to a speculative bubble in housing prices. Inflation-adjusted housing prices increased 85% from 1998 to 2006 to a record $275,000. As the sheer amount of mortgage debt piled up, Wall Street designed innovative ways to pool these mortgages into leveraged derivative structures. The ratings agencies were quick to put their stamp of approval on these structures, typically assigning the highest possible ratings on pools of regionally diversified mortgages. Boasting historically low default rates and attractive yields, these securities helped prop up Wall Street earnings for years.

What no one seemed to consider was the effect of home price depreciation (HPD). Financial engineers all but assumed that its polar opposite, HPA or home price appreciation, was virtually assured in an expanding economy. As prices became more earthbound, mortgage-backed paper valuations slowly started eroding. The first chink in the armor became apparent in July 2007, when several mortgage-backed hedge funds operated by Bear Stearns collapsed. Eventually, the contagion spread to homebuilders, and before long, banks found themselves saddled with nearly valueless mortgage debt on their balance sheets--so much, in fact, that loaning money became increasingly difficult.

The lack of available credit created a vicious cycle. Companies that had had no trouble getting revolving debt for day-to-day needs found themselves struggling to operate. Many responded by laying off employees, which had a deleterious effect on retail sales. Reduced consumer spending--usually the lifeblood of the U.S. economy--caused more job losses and foreclosures.

It is difficult to overestimate the result of such a crisis. With such names as Merrill Lynch, Bear Stearns and Lehman Brothers out of the picture, Wall Street will no longer be the same. The remaining investment banks have been forced to re-tool into traditional banks. As leverage comes down, earnings and return-on-asset bogeys will drop dramatically. The financial world as we know it is changed forever.

Such a monumental change in the investment landscape in such a short amount of time has resulted in indiscriminate selling in corporate debt. Out of all forms of debenture, loans--which sit at the top of the food chain in the corporate structure--are likely the most attractive. "Investors are shell shocked. At this point, all conclusions about the returns of corporate debt can be thrown out of the window," says Mike Revy, a principal of Los Angeles-based Froley, Revy Investment Company. "With the vast majority of loans priced for a depression instead of a mere recession, negative psychology has taken over the markets. The inmates," he says, "are running the asylum."

Among those most interested in senior loans are, ironically, stock investors. Moreover, according to Standard and Poor's, the recovery rate for corporate loans in a bankruptcy scenario is 74%, compared to zero for equities. Stocks sit at the bottom of the capital structure, while debt holders get any proceeds from an asset sale.

What really make these loans tempting is their yields, which are currently in the low-to-mid double digits. Sporting a much better return-to-risk profile than equities, loans seem attractive even to aggressive investors.

Even so, they are not flying off the shelves. Historically, the biggest buyers of loans are banks, which typically hold about 60% of such paper. Collateralized loan obligations (CLOs)--leveraged investment structures bought by pension plans and other large investors--account for about one-third of the demand. Hedge funds comprise the rest of the market. Forced de-leveraging of these players due to losses in mortgage paper and lack of liquidity forced loan prices down significantly. At this point, loan yields imply that defaults will rise to levels not seen since the Great Depression. "The value is there; the question is who is left to scoop it up?" asks George Feiger, CIO of Contango Capital Advisors in Berkeley, Calif.

The best way to gain exposure to such debt, according to Feiger, is through closed-end funds. "These funds in many cases are trading at significant discounts to net asset value and are an accessible way to participate in the market," says Feiger. "Investors may have to wait a while until valuations bounce, but they will receive a hefty dividend along the way."

What about investment-grade bonds and high-yield debt? Although lower in the capital structure and with less protection against default, these alternatives nonetheless offer tempting yields. Credit spreads are at all-time highs. Like loans, better quality bonds have sold off along with the rest of the market. Mutual funds are a good way to gain access to the asset class.

Although corporate credit is trading at rock-bottom prices, there is no guarantee that prices will bounce back quickly. The lack of natural buyers may create an L-shaped bottom in the asset class, but if positions are wisely chosen, hefty interest payments (and, hopefully, minimal bankruptcy issues) will reward investors along with the eventual recovery in valuations.

Hedge Fund Transition

Indeed, hedge funds are wedged between a rock and hard place. The good news? About half of all such unregulated partnerships have weathered the financial storm of 2008 in remarkably good shape. The other half, however, are on life support.

Since many hedge funds hold leveraged positions in fixed-income securities, the credit crunch hit them especially hard. Changes in short-selling rules made immunizing portfolios against the market downturn especially problematic. And finally, lack of liquidity forced many funds to impose restrictions, forcing their largest investors (pension funds, insurers, etc.) to divest themselves of their easiest-to-sell securities. In most cases, that means offloading equities, which only exacerbates an already perilous bear market.

It's not that hedge funds have done worse than the overall market. But most funds are negative for 2008--something that investors in these partnerships pay big fees to insure against. And now that this has happened, the industry is bracing for huge redemptions: perhaps 30% of all monies invested in hedge funds are headed for the exits.

Even so, there are some strategies that show promise for 2009 and beyond. Thanks to the current liquidity crunch, many solid hedge funds (Millenium, D. E. Shaw, Tudor) can now be bought in the secondary market for a discount to NAV. These NAV discounts can be instantly realized in the month of purchase.

Says Derek Drummond, a hedge fund consultant in San Francisco: "The bulk of hedge funds will eventually be forced to become more investor-friendly, with more liquidity and transparency. They will engage in more exchange-traded transactions and less in over-the-counter instruments. But there will be a small group of extremely large, successful funds that will still be able to run things status quo. This is the next step in the evolution of the industry."

Likewise, hedge funds-of-funds will become more open about their holdings. Even with all the problems the year has brought, hedge funds will survive. "Investors will always be intrigued with equity-like performance with much less volatility," Drummond says.

Opportunities in hedge fund investing are similar to those of all asset classes. While compelling valuations abound, it will take thorough analysis, solid planning, and intestinal fortitude to take advantage of current market opportunities. For advisors who have such attributes, the future is nearly limitless.

Ben Warwick is Chief Investment Officer of Quantitative Equity Strategies, LLC, in Denver, Colo. and Memphis-based Sovereign Wealth Management, Inc.

Reprints Discuss this story
This is where the comments go.