The Great Hedge Fund De-Levering Event Has Arrived

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By David Goldman :

Today's 400-point + plunge in the Dow was driven by capital calls on hedge funds, whose ballooning assets constitute the last big bubble in world markets. The surge in hedge fund assets to $2 trillion at last count, created a levered market sector vulnerable to investor withdrawals and hair-trigger sell decisions.

Stocks are stupid cheap. A utility paying a dividend yield of over 5% is a no-brainer trade against a 10-year Treasury yielding 2.45%, especially when the utility dividend is taxed at a top 15% rate and the Treasury is taxed at ordinary income tax rates. Narrow corporate bond yields indicate a very low level of risk associated with these earnings. We have never had a market crash of this magnitude in the past without a collapse of the corporate bond market. That alone tells us that something very different is at work. No one can fund a retirement at 2.45%. The problem is that the people who need retirement income are in no position to buy equities, and the investors with the liquidity to buy equities face massive redemptions.

On fundamentals, the stock plunge makes no sense. We've never had this kind of market bloodshed with a corporate earnings above 7% (and well above 8% on a forward-based bottom-up estimate), and the monetary authorities ready to provide unlimited liquidity to the market. Corporate earnings are solid-we aren't talking about the phony financials' earnings of 2006 or dot.coms with burn rates of 2000. The problem is one of market segmentation.

90% of US equities are held by the top 10% of the population in terms of net worth, that is, households who are more concerned about capital preservation than income. 90% of US households have most of their net worth in homes or in small business equity, and remain paralyzed for the duration. Pension funds and insurers should be massive buyers of dividend stocks at these levels, but have little dry powder. The equity market crash of 2007-2008 forced them into bonds, and their book yields remain much higher than the yields available. It makes little sense for them to liquidate assets now booked at a premium in order to buy into the equity market.

The investors who care about retirement yields-individuals and pension funds-both are sidelined for different reasons. Hedge funds, who have had a dreadful year after accumulating enormous inflows, have no choice but to raise cash.

In the background, there is a truly deflationary event: the prospective bankruptcy of Italy. An American recession or even slow American growth would be devastating for the Italian economy. During the year through April 2011, Italy's exports grew by 12%, and imports by a slightly higher margin. Nearly a third of that growth was in exports to the US; most of the rest was in exports to France, Germany and Switzerland. Growth in emerging markets had a negligible effect on Italy's export profile. Italy's economy, in short, has no buffer from the sources of world growth, and a great deal of exposure to shrinking demand in traditional advanced-sector markets. Political paralysis, corruption scandals, and general fecklessness make it extremely unlikely that the Berlusconi government will confront the crisis with the new measures required to stabilize its bond market, the largest in the world after the US, Japan and Germany. Sophisticated opinion in Europe is banking an Italian debt restructuring, with the European financial stabilization fund expected to intervene in order to prevent a meltdown of the Italian banking system. A sale of major Italian banks at distressed prices is the likely result.

The great deflationary wind blowing through markets has brought down all asset prices except for those that directly benefit from deflation, namely bonds. The fact that gold fell along with other assets makes clear that this is not a traditional liquidity event, in which gold acts as a hedge against an inflationary central bank response, but rather a contraction of overall risk appetite.

Stocks remain cheap-stupid cheap, in fact-and I do not recommend selling into these distressed levels. Little by little, "real money" investors seeking income will find their way back into the market. The world does NOT have too much debt-debt is what the whole world wants to buy at the moment-but too little earnings. And the only place to find earnings is in solid, blue-chip stocks.

But there are falling knives which no-one should try to catch. The financials will continue to underperform, especially in Europe. The collapse of government bond yields is another blow to our zombie banking system, which has attempted to make a living by borrowing at zero from the Federal Reserve and lending to the Treasury at zero plus. The "plus" just got much smaller. Conservative stocks with strong franchises-global exporters, utilities, and beaten-up natural resources companies-represent the best value.

See also Will Tax Break Lift The U.S. Dollar? on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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