The Current Stock Market Cycle

I often worry about investor trends in the stock market. As you’re well aware, most things in life tend to go through cycles — the stock market illustrates this reality perfectly.

Twice in the last two decades, the stock market lost an enormous amount of its value because prices were out of line with underlying fundamentals.

Stock prices started doing well, and investors took notice. More people began participating in the market and stock prices moved even higher. The stock market became front page news in newspapers, and even more individual investors starting buying stocks. Then, of course, the market corrected itself.

Individual investors learned a great deal about the nature of economic and “financial market” cycles over the last 20 years. Now I’m starting to see institutional investors jumping on a new bandwagon, one that carries much greater potential risk.

In the absence of a clearly defined trend, investment capital will migrate to the best potential returns. Institutional and individual investors are alike in this regard. Right now, institutional investors are investing large sums of your money in hedge funds. As you might know, these funds aren’t regulated very closely, and they can often “play” both sides of the market. They also make much greater use of derivative securities, which implies a greater use of leverage.

According to some industry reports, the U.S. hedge fund industry has doubled in size in just the last four or five years. Who is responsible for this dramatic growth — institutional investors, and specifically pension fund investors. That’s right, more and more of your retirement money is being allocated to higher-risk investment pools.

The debacle of Long-term Capital Management (what a great name) several years ago — which ran a hedge fund that became overleveraged with losing positions, collapsed, and needed to be bailed out by Wall Street and the Federal Reserve — was the first shot across the bow. It was the first large-scale hedge fund to impale itself, and it almost brought down the entire financial system in a short time.

Hedge funds and derivative instruments are here to stay, but policy makers need to be stricter in their regulation of these capital pools, especially when it comes to pension fund customers.

My prediction is that it’s only a matter of time before the next financial market cycle gets out of hand and we see a correction or a crash. The next one, however, is likely to be caused by institutional investors and related to the use of hedge funds.