Zeev's Turnips Patch-No Politics (ZEEV)

[marketmaven]

Melcher: Investors, in short, should remain wary. Stocks are anything but cheap, and a day of reckoning still lies ahead.

Barrons -Abelson Blog...8April05
http://online.barrons.com/article/SB111300288795702464.html?mod=b_this_weeks_magazine_columns

OUR NOT ENTIRELY ebullient view of the risk-reward ratio in the current stock market, we're pleased to note, is shared to some significant extent by James Melcher. What gives us pleasure in so noting is that Jim is a very savvy fellow, a seasoned veteran of the investment wars and, despite the fact that he runs a hedge fund, he's kind to little children, helps old ladies across the street and seems a genuinely nice guy. Jim also thinks this "is about as dangerous as any market I've ever seen."

And Jim has seen a lot markets, dating back to those wonderful, zany, joyous ones in the 'Sixties. What's more, as that sobriquet "battle-scarred veteran" we hung on him in the preceding graf suggests, he has been more than an interested spectator all these years; rather, he has been a knee-deep participant, and not only survived but prospered.

Jim's hedge fund is called Balestra Capital Partners and he also runs, from his office digs in New York, an income fund and a version of a fund-of-funds that invests in, of all things, other hedge funds. He was the subject of a nicely turned profile by Jack Willoughby last summer in this very magazine. What more recently piqued our interest and prompted a call to him was a periodic communiqué he sends to clients and, hopefully, stray types who can read without making their lips tired, in which he unburdens himself of his take on the world at large and that particular portion of it occupied by the investment scene. Perhaps what we find most striking about Jim in chatting with him and perusing his commentary is that his investment philosophy is akin to the principle article of the physician's creed: Do no harm. This abiding concern for conserving money, especially other people's money, makes him something of an anomaly in the money-management business. But as his fund's record strongly argues -- from 1999 through 2004, it appreciated a cool 263%, versus a rise of 7.5% in that span for the S&P 500 -- a decent respect for risk is no detriment to performance. Quite the opposite.

What bothers Jim about the market as much as anything is that bull markets, like the great one that began in mid-1982, typically are born when everything, from the economy and stock values to investors' emotions, is down in the dumps. By contrast today, the economy ostensibly is buoyant, profit margins are the best ever, equity valuations are well above the mean and for all they may evince temporary gingerliness, scratch investors and right below the surface they're still bullish.

Another reason he's uneasy is the inordinate growth of the financial sector. Earnings of financial companies now account for some 40% of all corporate earnings, up from a mere 4% two decades ago, and they represent 25% of total stock market capitalization versus 5% back in the 'Seventies. "It would seem," he comments wryly, "that most Americans are making a living lending money to each other." Thanks to the wonders of cheap credit, we've been spending more than we've earned these past several years, he sighs, but that hasn't deterred us from borrowing on, and cashing out the equity in, the wildly inflating value of our home sweet homes.

What also disturbs Jim -- and this may get him drummed out of the Hedge Fund Marching Band and Chowder Society -- is the proliferation of, yes, hedge funds. As he puts it, "over the past few years, the number of hedge funds has doubled to approximately 8,000, with assets approaching $1 trillion. With leveraged borrowing and heavy use of derivatives, their ultimate buying power has become truly massive. Competition has limited the profit opportunities and encouraged additional risk-taking." All of which, he reckons, means the potential for a 1998-style, hedge-fund-caused disaster (think Long-Term Capital Management) is far from small.

And he entertains the usual macro demurs: The U.S. financial system is dangerously stretched and vulnerable, while the Fed's ability to contain a serious break in any part of that highly interconnected system has become quite limited. Derivatives are a monster accident waiting to happen. The global "growth mantle" has passed to Asia and Eastern Europe, and the great growth years of the U.S., Japan and Western Europe are over.

For all his negative stance, Jim is not a blinkered bear and thinks it's always possible the market could meander along for a period, even go up, before the great sea of liquidity starts to run dry. He's fully hedged, with a portfolio 35% net long and 35% net short. Most, but not all, of his longs are foreign equities, notably in such emerging markets as India, Russia and Brazil. He's short largely through puts, and one of his favorite trades here is being short junk bonds and long Treasuries.

His final thought: There exists a significant risk of financial turmoil and a major bear market. He doesn't know, obviously, when it will happen or the precise precipitant. But, he asserts, "the risk is serious and perhaps imminent."