Michael Steinhardt questions whether today's
market is telling us much.
Volatility is often cited as a major reason why
individuals avoid investing significant assets in equities. Except that
until this May, there has been very little evidence of volatility since
the Iraqi invasion in the spring of 2003.
For several decades, a number of observers have observed that the short-term volatility of the stock market has grown increasingly detached or decoupled from the real economy. That subject was addressed by the legendary hedge fund manager Michael Steinhardt, who retired a billionaire in the mid-1990s and became a philanthropist, at a conference on June 15 sponsored by Sincere & Co. in conjunction with Tel Aviv University.
"If you consider what's happened to the market recently, there has been, for the first time in a while, volatility and downside volatility," Steinhardt noted. "Some of us used to view it as a friend; some of us used to view it as an enemy."
Of course, increased volatility could be the result of significant events, such as Fed Chairman Ben Bernanke's short-lived honeymoon with Wall Street, the prospect of higher inflation and interest rates or the possibility of a weaker economy. "My thesis is that the real volatility is not in the real economy, it's in the portfolios of investment managers," Steinhardt said.
This has been an increasingly prevalent phenomenon ever since the stock market collapsed in 1987, he continued. "The stock market has always been viewed as the precursor to something serious. [But] since 1987 all of the stock market volatility has been confined to the market itself," he contended.
One major difference Steinhardt detected between the pre-1987 markets and today's was that there used to be a multitude of long-term investors. He then turned to the audience of assembled advisors and asked them to define a long-term investor. When one advisor said ten years, Steinhardt agreed that investor was definitely in it for the long term.
Then another advisor, Lewis Altfest of L.J. Altfest & Co., said, "Two to four." Steinhardt's response was, "Days or years?" and Altfest cited the latter.
"Volatility [today] is a function of an extraordinary concentration of money in fewer and fewer hands with very similar mentalities," Steinhardt opined. Pressure on short-term performance is intense, since most of the hedge fund and mutual fund business is compensated on a "once a year" basis.
At least that hasn't changed so much. When he ran his own hedge fund, Steinhardt acknowledged that he lived his investment life in "a state of constant anxiety because I thought I was being paid so egregiously well that I had to be the best manager in America. Not the sixth best."
In today's environment, Steinhardt thinks the hedge fund business may be facing a moment of reckoning. "In today's world, the stock market will continue to return 9% or 10% if you're lucky," he declared. "How do you find room to pay someone 20% [of the profits] and 1% [in management fees]?"
"Hedge fund managers are the best paid people by far, way ahead of entertainers, athletes and CEOs," he continued. "The world isn't going to allow performance of 8% a year and pay 20% of the profits to the manager. Something's got to change."
But with the U.S. equity market down 10% from its highs and foreign markets down as much as 25% in mid-June, Steinhardt remained skeptical that there was a meaningful reason for it. "What's happened here?" he asked. "Sure, housing is weak and there's substantial overbuilding in places like Miami. Bernanke can't speak like his predecessor. Greenspan wasn't a great economist, but he was gifted at the use of nuance. Six months from now when you ask what happened, you'll be hard-pressed to come up with an answer."
Even with the recent spike in volatility, equities have traded in a fairly narrow range since recovering after the invasion of Iraq in 2003. "Look at the range in the stock market over the last few years; its pretty narrow, even with the war in Iraq and the price of oil," Steinhardt said.
Looking into the future, Steinhardt turned his attention to commodities. "The theory is that each year China creates 50 million new consumers and that creates a demand for gold, oil, copper and other commodities," he said. "There's a view that if you buy commodities, in the long term, you'll be rewarded. I don't believe it."
Peering into a proverbial crystal ball to try to pinpoint the greatest global danger, Steinhardt commented matter-of-factly, "I don't think we can see it." Terrorism is an obvious problem and so is the potential of nations like Iran and North Korea to develop nuclear weapons.
"We're all a product of the last tick," he remarked about this information-driven society. "How many times after 9/11 did we hear, 'The world's a different place.' That tick has begun to fade. Still, three months after 9/11, if you asked what the odds were that there would be no major terrorist attacks on the U.S. through 2002, 2003, 2004 and 2005, most people would have said [the odds of no attack were very small]."
Another major threat, at least to the financial markets, is the explosion of derivative instruments. "For the last 20 to 30 years, there's been a sense that growth driven by derivatives had some deep underlying mystery and somehow, some way, it would all fall apart, like Long Term Capital Management," he explained. "To some degree, that fear still exists."
Yet derivatives can help reduce risk. "Over the years, my net exposure to the stock market averaged 35% [thanks to derivatives], and with the average mutual fund it's 90%," Steinhardt noted. "So who is more at risk?