Five years ago India had an election. There was a surprise victory for the Congress-led coalition over the BJP and the market fell 20% in a day. This marked the low and the market subsequently quadrupled over the next three and a half years. As it turned out the effect of having to accommodate some of the left-leaning coalition partners on economic policy was somewhere between immaterial and zero.

This week the election result caused a 20% move up in the market as Congress will be less beholden to minority coalition partners. Good news if you are a Congress MP looking for a plum job, but rather less obviously great news for investors. Indeed for the IT, pharmaceutical and other export orientated industries the result is an unambiguous negative as the 5% appreciation of the Rupee will decimate their earnings if this level of the currency is sustained. The bulls will tell you that reforms will now come thick and fast and that infrastructure spending will accelerate. With a federal budget deficit of 10% already (and a lot more if you include state deficits) we doubt much more is feasible. Yet the big contractors have risen 40% in a few days, and now trade on 25x earnings. Banks and other high beta domestic plays have moved in similar fashion. Again we struggle to rationalise this. The market had not been weak in expectation of a poor result prior to Monday’s bounce – it had risen 50% in the two months prior to the election.

Political rhetoric is one thing, but policy action in a globalised world tends to be determined by the realpolitik of the market which force most governments to follow a centrist agenda. Just look at ‘new’ labour in the UK, or the SDP and CDU effectively swapping places in Germany. We invest in companies, not politicians, and the Indian market is way ahead of itself. Time to make some money on the short side….

Fixed asset investment figures for the first 5 months showed a 33% increase YoY. For May alone it was up 38% YoY. Within that real estate investment in May was up 12% versus a 6% improvement in April.  Despite these big numbers, the stimulus measures continue.

Auto numbers were up by a similar quantum YoY supporting evidence of renewed consumer confidence.

We have said before that China cannot save the world single handed but that it can save itself. The evidence appears supportive.

Although I have never been a marketer, and am firmly on the buy side, being part of First Avenue Partners, effectively a marketing firm active in hedge funds, private equity and real estate, as well as a hedge fund seeder, gives me a very interesting view on what investors want. Being responsible for due diligence and manager selection for the hedge fund practice, I spend most of my time looking at the hedge fund industry, but I also keep track on the private equity and real estate fund management industry as there are often interesting overlaps.

It was very clear that in 4Q 2008, investors simply wanted out, they wanted to redeem from their managers and they often wished they had never been invested with the funds they were invested with, that they had never got involved in the dreadful investment game, and that they should all have been dentists instead. You get paid for pulling teeth, patching teeth, straightening teeth, and poking around in teeth. But the more teeth you pull, patch, poke or straighten, the more you get paid. In those times, investing was like having your teeth pulled and paying for the pleasure, a bit like being on the other side of the drill. It was not material which investment strategy you were in whether it was equity long short, merger arbitrage, relative value, event driven, credit, fixed income or macro. The pain was less in macro and risk arb, although so widespread was the pain and so punchdrunk were investors by the end of 2008 that many did not even realize that risk arb actually turned in a relatively strong performance, losing some money but mostly protecting capital for the year. Global macro made money, but even macro as a group saw investors making net withdrawals from the strategy. Investors wanted out. They just wanted to sell sell sell. Put or Call? Doesn’t matter. Sell sell sell. The redemption terms of hedge funds made it possible to forecast the degree of outflows since there is usually a long notice period of anywhere from 15 days to 180 days, although its more usually clustered around 30 to 45 days. Also, in the industry, people talk. And misery likes company. The anticipated and realized redemptions for September 2008 was high, but December saw a crescendo. Sentiment was terrible. And then some managers started suspending redemptions and applying gatesand side pocketing illiquid investments. For the most part, if you were in ‘traditional’ hedge fund strategies such as equity long short, merger arbitrage, statistical arbitrage, relative value, convertibles, global macro and CTA’s, you would have lost money but you would have got your money back. If you were in the less liquid end of credit, levered loans, LCDS, private convertibles, PIPEs, quasi private equity (PE without control, lovely), asset based lending, chances are your manager would not be able to get you your money back even if they wanted to. And to be fair some of them wanted to.

Human beings are predisposed to extrapolation. Estimates for the March 2009 redemption volumes ran to the fanciful. In the end, over a 6 to 9 month period ending March 2009, a 2 trillion USD industry had been halved. Hedge fund managers who once were Masters of the Universe were humbled. Funds that were closed to new investment were open again and their managers had to suffer the ignominy of presenting at capital introduction events.

We have seen evidence of interest in distressed credit, global macro, equity long short and convertible arbitrage.

Distressed credit is a strategy which according to investor survey’s conducted earlier in the year continue to see a lot of investor interest. In fact, distressed credit was a strategy offered in volume in late 2007 and which in 2008 burned a lot of investors. One factor in the disappointment was the lack of corporate defaults in 2008. Distressed investing worked only if you were ultra selective and if you went where the defaults were underway and not where they were waiting to occur. The place to be was arguably in the ABS market where RMBS and their CDO’s were already defaulting . In corporate credit, default rates are only now accelerating. The market expects default rates in double digits by the end of the year, arguing that investors were too early in 2008 but are likely to be right this time.

Global Macro in 2009. Think againwhere I argue that the easy trades are done, that the opportunities are still there, but the way one captures them, and the subspecies of manager required for the job, are different. But who am I to argue with the legions of investors who want to invest in Global Macro?

Equity long short is a perennial strategy. In the turmoil of the last 12 months, the strategy has had mixed success. The traders have done well as equity markets abandoned fundamentals and traded almost purely on psychology. There are signs that idiosyncratic risk is beginning to rise and that the day for the stockpicker is not far away. Of course the holy grail is finding the investment manager who both understands fundamentals and has the ability to trade, who has a full arsenal and can deploy the right weapon for the right battle for the winning of the war. As investors restore their risk, equity long short is one of the strategies that ranks high.

, the hedge fund survey’s find that there is a significant preference for lower fees, particular on funds of hedge funds, but also on the underlying funds themselves. My own anecdotal experience is that investors do not so much object to the level of fees but rather feel that fees could be better designed to be fairer and more efficient at aligning the interests of the manager with those of the investor. There is an argument that talent is relatively scarce, and that the current environment highlights this and therefore that fees should be more differentiated. I am fortunate to sit in the middle of a private equity, real estate and hedge fund practice and have the benefit of assimilating best practice from all three areas. PE style fees which pay on realization and are subject to clawbacks are attractive but should be used carefully lest they introduce unexpected and adverse behavior by the manager. Let the fee design fit the fund structure, fit the strategy. What we are seeing among investors is a definite improvement in the level of sophistication and understanding with regard to fee design.

In the area of liquidity, the recent hedge fund investor surveys point unequivocally to a preference for liquidity. Long lock ups, side pockets and gates are definitely not preferred. Fund of funds in particular, are having to restructure their portfolios for greater liquidity to meet the terms they offer their investors. Institutional investors are also leaning heavily in the direction of strategies with better liquidity as they face balance sheet issues. It is left therefore to the private investors, the family offices, who have more flexible investment processes and mandates to take advantage of the value of liquidity. Longer gestation strategies are seeing considerable value, almost certainly because of the dearth of capital exploiting these very opportunities. Fortunately, it is heartening to see, among some investor groups, the appetite for longer duration investments. Arbitrage is a terrible thing to waste.

While investors remain cautious, there are clear signs that they are no longer in selling mode but are more in watching and waiting to invest mode. As always, this generalization hides a multitude of situations. The willingness to assume risk is a good thing. A cautious attitude to assuming risk can only be a good thing.

Stronger than expected payroll numbers. US markets rallied in the morning and fizzled at the close. A few weeks ago, this sort of better than expected economic indicator would have fueled a rally of at least 2% for the SPY and the Dow. What happened on Friday smells like distribution to me.  The reality is that things aren’t really getting better, they’re just getting worse more slowly.

I agree with Krugman, there is no V-shape recovery (http://www.bloomberg.com/apps/news?pid=20601068&sid=aATifebEMcHE&refer=economy). I think there is behavioural science angle to why the markets staged the recent sharp rally. 2008 was a shock. Very few people saw what was coming. In the abyss in Sep/Oct, many thought the whole US financial system was going to collapse. The rate of bad news grew exponentially, and many thought Armageddon was around the corner. Now the rate of bad news has slowed (which is viewed as good news in itself) and people have mistaken this for a recovery. Panic has been replaced by mere anxiety. This change in mental state makes people feel better. It’s akin to losing 90% on investment but then making a 100% back. You feel better, but you’re still losing a bundle. The fact of the matter is things are still bad. What would economists have thought if they were told the US unemployment rate would be 9.4% in 2009 back in 2007?

In the Asian markets last week, we saw the rally tiring.  Markets rising earlier during the week, then falling and flatlining towards the close . More liquid markets like the HSI, running into serious resistance at the 19,000 level. The proverbial battle between the bulls and the bears continues. My guess is that the markets will probably sideways trade from here, with dumb money trying to buy on dips and smart money giving them stock at these levels, stopping the advance. It is true that certain markets are in bubble mode again, e.g. Hong Kong real estate, with lines of people queue in the rain for such crap projects such as “Lake Silver” in the New Territories. Hong Kong developers are taking advantage of this frenzy by putting up prices. The Lex column in the F.T. last week gives a good account:

It’s like the crunch never happened. Sino Land, the fifth-biggest Hong Kong property developer, plans to raise pricesat a sparkling new complex in the New Territories by up to 5 per cent. In five days of selling Sino has offloaded about three-quarters of the apartments on offer; the previous weekend an estimated 30,000 people had queued in atrocious weather to view them.

This is a bona fide mini-bubble. The six big listed property developers have seen their aggregate market capitalisation more than double since October last year. Sell signals are blinking red: the trailing price/earnings gap between the property sector and the benchmark, which has averaged 200 basis points over the past five years, is now a mere 40. Residential property prices, meanwhile, have climbed back up to December 2007 levels; the recent peak, in March 2008, is a mere 15 per cent away. Hong Kong’s banks, awash in liquidity, seem happy to respond to demand. According to the HKMA, total outstanding residential mortgage loans were up 1.3 per cent, year on year, in April, while overall lending shrank by 0.5 per cent.

Over the long term, however, property prices have never decoupled for long from economic fundamentals. Prices and median household income are pointing in opposite directions. Unemployment may reach 7 per cent this year, from 5.2 per cent currently. GDP was down 4.3 per cent in the first quarter from the fourth – the sharpest decline in history.

It is odd that Hong Kongers should be so in love with breezeblocks and mortar. Rental yields, falling since mid-2008, are near a two-decade low. Even with the recent lift, nominal prices per square foot are no better than where they were in January 1994 and more than 30 per cent adrift of the twin peaks they hit in 1997. A new generation of buyers should gird themselves for disappointment.

What to lookout for next?  For the moment I think the markets will trade sideways. There will be a trigger point when the markets will either continue their upward advance or reverse course. As one commentator put it a lot will depend if we face a severe inflationary/deflationary scenario.

Actually the scenario on equities depend whether your view in the near term calls for inflation or deflation. If you know which one wins then you should be able to properly assess your equity and bond exposure.

In short, the S&P 500 should be below 666 by September and probably much lower by 2010 if the deflation scenario materializes so let’s hope that the market is right and that we have stagflation.

The recent rally has been fuelled by a massive injection in liquidity by the central banks around the world and investors are expecting higher as a resul
t of the inflated FED balance sheet.

However, where I think the market is wrong and this is why I have remained so bearish lately (not because I want it but) is the velocity of that money supply is nil. Banks are simply not lending money. Therefore, the mass of money is staying in the FED and banks balance sheets but is not flowing into the real economy.

The consequences are: the deflation will remain the biggest threat and deleveraging will continue for consumers and corporates. Once the market has realized that (and I may be a bit early in my call but who knows how to time these things) then they will fly back to safety which means buying US 10 years treasuries and selling equities. My gut feeling (for that is worth) is calling for the market to double bottom by September.

If you want a similar period of reference you have to look at the depression of the 30s or the big recession of the 1870s. You can’t compare the current recession to the 90-91 or the 70s because they were different animals.