Blog - Investing Notes

April 18, 2005 – An Engine Driving the Market to a Lower P/E?

What if the rapid growth of hedge funds is moving money from managers who cannot sell short (at mutual funds) to managers who can not only sell short but also do it with leverage. Might this shift drive the market downward to lower and lower price/earnings ratios (P/E)?

Jorgen Vitting Andersen wrote an August 2003 paper on "Could Short Selling Make Financial Markets Tumble" that supports this thesis. The author concludes that financial markets may have entered a new era in which increased short selling by hedge funds could reinforce any downward market moves. However, this paper is long on theory and short on both historical perspective and data.

In our blog entry of 1/11/05, we summarize a December 2003 study by Owen Lamont and Jeremy Stein on the countercyclical nature of aggregate short interest during 1960-2002. Because of weak (strong) performance in a rising (falling) market, short sellers lose (gain) capital and scale back (up) aggregate short interest. A trend-following mind set on the part of short sellers would therefore push the market lower and lower. A dramatic growth in resources available for short sales (via hedge funds) would amplify this effect.

To test this idea further, we collect the following data:

• From the Investment Company Institute, equity mutual fund assets for 1990-2004.
• From Barclays Capital, information on hedge fund assets from 1990-2003. From various press articles, hedge fund assets at the end of 2004 were just over $1 trillion. (Note that Barclays' global numbers are quite different from the U.S. numbers in this Securities Industry Association report.)
• From Standard and Poor's, S&P 500 operating P/Es from 1990-2004.

The following chart depicts both the growth in global hedge fund assets and the ratio of these assets to equity mutual fund assets over the period 1990-2004 based on year-end data. It shows that global hedge fund assets grew very rapidly the past few years and that the ratio of global hedge fund assets to equity mutual fund assets is relatively high. Hedge fund assets were relatively depressed during Internet bubble years 1998-2000. They more than recovered during 2001-2002.

The next chart shows S&P 500 operating P/E and the ratio of these assets to equity mutual fund assets over the period 1990-2004 based on year-end data. P/E is low when hedge funds are relatively strong compared to mutual funds, and P/E is high when hedge funds are weak. If investment dollars flow disproportionately to hedge funds in coming years, the result might be a lower market P/E. However, it is not obvious from this data that hedge funds will outgrow equity mutual funds in the future.

In summary, it appears that rapid hedge fund asset growth does indicate a lower market P/E, but the current hedge fund strength may be a typical cyclic event.