Are the Capital Markets Headed for a Major Correction and Will Hedge Funds Help or Hurt?

(HedgeCo.Net) Major corrections in the capital markets are a risk that investors must always consider. Experience shows the question is not if a major correction will happen, but when. The challenge for investors is to determine and prepare for the timing, magnitude and longevity of an inevitable correction. Responsible risk management requires investors to consider whether they are properly positioned and prepared to ride out the storm when the correction happens.

Events of the past couple of decades have led investors to expect markets to rebound quickly from a major correction. Seemingly forgotten is the worst sell-off of the US stock market, which began in 1929 and resulted in a decline of almost 90%. It took 23 years to recover. For those tempted to dismiss this as outdated data, take note that the Nikkei index hit an all-time high of approximately 39,000 in 1989. More than 26 years later it is still below half its peak.

Has the probability of a major sell-off increased?

We have recently heard some of the top investors in the world share very negative comments on their outlook for the capital markets. Jeffrey Gundlach speaking with Business Insider stated, “The artist Christopher Wool has a word painting: ‘Sell the house, sell the car, sell the kids.’ That’s exactly how I feel – sell everything. Nothing here looks good.” Bill Gross tweeted: “Global yields lowest in 500 years of recorded history. $10 trillion of negative rate bonds. This is a supernova that will explode one day.”

With sovereign interest rates hovering at record lows, many investment professionals believe we are experiencing an unsustainable bubble in the fixed income markets. Fitch Ratings estimates that as of mid-August, $13.4 trillion of bonds were trading at negative interest rates, representing approximately a third of all outstanding global debt. Governments are issuing debt at negative interest rates while running up unsustainable deficits. This deficit data does not include unfunded liabilities for public retirement and healthcare programs, which most experts agree are unsustainable in the long term. Compounding the pressure, spreads have tightened as investors reach further and further for yield. It is difficult to predict when capital market bubbles will end, but typically the longer they continue, the worse the final outcome.

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Donald A. Steinbrugge, CFA
Managing Partner
Agecroft Partners, LLC
103 Canterbury RD
Richmond, VA

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