Sliding Stocks Carry Hedge Funds Downwards, Few Worry of Bubble

2014 has been a rough year for internet tech and biotech stocks. Despite their 2013 gains, recently Google has fallen around 10% since last month, and Valeant Pharmaceuticals Intl Inc. has fallen over 17% since February. While the recent dip in the stock market has impacted many investors over the past few months, according to the Wall Street Journal, many top hedge funds have been hit especially hard.

It sounds like many hedge funds, not wanting to be left behind, jumped into stocks in the beginning of the year after watching last year’s bull-market rally. However, those that increased their exposure to last year’s darling companies have often seen their lackluster returns drastically missing the S&P 500 average. For instance, while the S&P 500 has been down around 1.2% since the beginning of this year, the $28 billion large hedge fund Viking Global Investors LP has fallen more than 4% in both march and april. John Thaler, a former analyst at the tiger cub hedge fund Shumway Capital, saw his $2.2 billion JAT Capital Management fund take a 10% loss for the year (on a side note, the tiger cubs are hedge funds that spun off of Julian Robertson’s famed Tiger Management Corp hedge fund that, although incredibly successful in the later 1990s, eventually went bust when its largest holding in U.S. airways crashed in 2000).

The culprit behind the lackluster returns of these hedge funds, according to Brian Shapiro, founder of the hedge-fund analytics company Simplify LLC, is that duplication has become common among hedge fund managers. Many firms end up placing the same bets, either by independently coming to the same conclusions about stocks or, more likely, because they hope to ride a momentum wave by copying the strategies of other hedge fund managers. This inevitably pushes up the price of the asset that everyone is buying, and creates “wealth” on paper, but if a few of these managers get smart and decide to sell to lock in their winnings, the stock begins to sink all of their boats will capsize together.

To me, this kind of speculative behavior seems to be the kind that could form a bubble, since people are attempting to make a profit on the rising price of an asset by investing in places where others have already made money. However, according to Vikram Mansharamani, a lecturer at Yale University who has written extensively about how to detect a bubble, this may not be the case.

In an interview with the Wall Street Journal, Dr. Mansharamani outlines 3 red flags that may signal a potential bubble.

  1. Rapid Rise in Prices: In the beginning of a bubble, investors push up the price of an asset quickly. For instance, in the year before the dot-com bubble the Nasdaq rose 110%. Also, the price spike might also be interspersed with panicked selling, says Professor Didier Sornette, who holds the Chair of Entrepreneurial Risks at the Swiss Federal Institute of Technology Zurich (ETH Zurich).
  2. Prices Breaking from Asset’s Underlying Value: Using the Shiller P/E, which is the market price for an asset divided by the 10-year inflation adjusted average earnings, a high ratio may indicate a bubble. For instance, while the median P/E ratio of large U.S. stocks has been around 16 since the late 1800s, but during the dot-com bubble the Shiller P/E surpassed 44.
  3. “Exciting”  innovation as justification for the price increase: If, in an effort to justify their irrational exuberance, investors point to new technological innovations as a rational cause for the price increase, there’s reason to be skeptical. This can be seen in both the dot-com boom and in the housing crisis (with the popularity of innovations in mortgage-backed derivatives). Overall, it’s important to remember that irrational people will find a way to rationalize anything.

By these criteria, the overall S&P 500 may not be in a bubble. Although the S&P 500 returned 32% last year, it’s Shiller P/E is only around 25, which is somewhat worrisome but not yet alarmingly indicative of a bubble. Professor Sornette’s models did, however, identify internet retail stocks and healthcare and life-sciences stocks as bubbles before the recent sell-off. As evidence, the Nasdaq biotechnology index has fallen more than 18% since the beginning of the year after last year’s rapid ascent.


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On the other hand, the famous Bitcoin does meet the criteria for a bubble. The price has exploded in the past year, rising from a low of around $120 last April to a high of near $1126 last December. Investors have also justified its ascent due to its “innovation” and “potential to change the world” (just see the website for a list of quotes from hyped up entrepreneurs, economists, and politicians), while the fact remains that few retailers currently accept payment in Bitcoin and there are no underlying assets backing the currency. This is not to say that Bitcoin, or a similar technology, won’t be important to the future of finance, it just suggests that Bitcoins recent gains are likely the result of hype and popularity.

Overall, It’s important to remain level headed and rational when investing, as even institutional investors and hedge fund pros can and often do make poor bets.