This article is a guest contribution by Neils Jensen, Absolute Return Partners.
"When the facts change, I change my mind." - John Maynard Keynes
Email this article | Print this article
In last month's letter I looked at the challenges confronting the world's baby boomers based on the assumption that we are in a structural equity bear market, which implies below average returns for equity investors for several more years to come. Central to this forecast is my expectation that household de-leveraging, which is now underway on both sides of the Atlantic, has much further to run. In other words, we are in a balance sheet recession. When that happens, debt reduction becomes the priority. Savings rise and consumption falls at the expense of economic growth.
Please note that this forecast is predicated on a 5-10 year time horizon. Within a structural bear market - which is characterised by falling P/E ratios - it is certainly possible to have cyclical bull markets, so it is by no means one-way traffic. As you can see from chart 1, since the 1982-2000 structural bull market came to and end, we have enjoyed two powerful cyclical bull markets; however, global equity prices remain at 2000-levels.
That pretty much sums up the key findings in last month's letter (which you can find here in case you didn't read it). This month I will look at an appropriate investment strategy for such an environment, so let's get started. I will make five specific recommendations. Here is the first one:
#1: Beware of echo bubbles
We are currently in what I like to call echo bubble territory. I assume that most of our readers are familiar with the DNA of an asset bubble (even if Greenspan isn't). Echo bubbles are children of primary asset bubbles and are usually conceived when monetary authorities respond to the bursting of an asset bubble by dramatically reducing policy rates.
In the current situation, banks have suffered the worst; low policy rates help banks rebuild their damaged balance sheets as they benefit from the steep yield curve. The dilemma now facing policy makers is that the extraordinarily low interest rates we currently enjoy are encouraging another bout of excessive risk taking before bank balance sheets have been restored and the economy is back on its feet again. If monetary authorities were to raise rates now in order to avoid the formation of echo bubbles, it would almost certainly kill the fledgling recovery. The pressure is therefore on them to keep rates low and for that very reason asset bubbles are often followed by echo bubbles.
So how do you spot a bubble? ...
Jensen continues his recommendations in this must-read issue:
#2: Do not benchmark
#3: Include uncorrelated assets
#4: Do not use leverage
#5: Prepare for yields to fall
The letter includes an excellent and handy "Periodic Table of Hedge Fund Return (Strategies)" which details how various types of hedge fund strategies have performed year-to-year.
Read the complete April 2010 Absolute Return Partners Letter [PDF] .
click to enlarge
Periodic Table of Hedge Fund Returns
Source: Neils Jensen, Absolute Return Partners, April 2010
