We had lunch this afternoon with a hedge fund manager who had some gloomy news for stocks. His message: there is no upside. We’re stuck here for a very, very long time.
“I look at the growth of US equities as the longest boom ever. But it’s over. It was based on lots of misinformation in the market, basically an underestimation of future profits. But we learned how to price assets from the long boom, and now everything is priced correctly,” he told us.
In his view, climbing stock prices over the past several decades were a caused of lengthening time horizons of investors combined with increased transparency in the markets. As time went on, investors learned more about the growth of profits at firms, and were increasingly willing to bid up assets prices based on this new information. That was a recipe for a long boom.
Now, however, the situation is very different. He argues that investors have become more sophisticated, with a market dominated by institutional investors armed with reams of information. It’s a situation he describes as “extreme market efficiency.”
“We’ve priced in everything, and we got it right. There’s no upside left in US equities,” he said. He adds a warning that downside surprises could remain in the market if past projections prove overly optimistic
Supporting his view is the fact that the major indexes are nearly flat or down over the past decade, with investors in equities losing out to inflation. But how does he explain the volatility we’ve seen?
“Prices went up because of temporary mispricings that occured due to economic
‘blind spots’ created by government intervention,” he said. In his view, artificially low interest rates create ‘calculational chaos’ by fooling people into thinking there is more wealth than there is. When investors wise-up, they inevitably sell stocks back down to their ‘rational price.’
He argues that the debt market is only now coming to terms with this. He believes that there will be less credit available forever as lenders adjust to a world of “fully priced assets.” Riskier corporate debt, which is often secured by equity pledges, will be particularly hard hit.
“If there’s no upside to equity, you don’t want to lend against it,” he explained.
Even the supposedly ‘illiquid’ market for complicated mortgage assets is correctly priced, in his view. He believes that banks are trying to arbitrage accounting and regulatory rules by holding assets at above market prices on their books but that the market is correctly assessing the prices as far lower. He doesn’t think that banks would sell the assets for the correct prices because he thinks that basically everyone agrees on the likely return on investment of the assets, eliminating the market for them to trade hands.
“There are no greater or lesser fools left for these things,” he says. “Maybe if they could sell them to ignorant individual investors who would overpay they’d see some gains above justification.”
It’s certainly a gloomy view for US equities. The good news, if you can call it that, is that he believes there are lots of markets ceded with opacity.
“Go south, young man, is my advice,” he said.
As a final note, he said that in the long run market inefficiency may return to US equities, bringing back potential upside.
“When people lose interest in equities, inefficiency will creep back in,” he said. “That will take 10 or 20 more years.”
He wanted us to add that he is neither long nor short US equities but has both long and short positions in emerging markets.
We made him buy lunch.
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