Renaissance Technologies, the world’s most profitable hedge fund, said there’s a “significant” risk of a correction in prices and is preparing for possible market turbulence.
While accelerating global growth, corporate tax reform and a business-friendly administration in the U.S. have contributed to market gains, it’s not clear these factors justify current valuations, especially in light of sovereign debt levels, Ed Hubner, the quant firm’s head of risk control, wrote in a December letter sent to clients this month.
The best global economic growth in seven years has helped stoke a multi-year rally in stocks. The current S&P 500 Index’s price-to-earnings ratio of about 18.6, compared with about 11 in 2011, may be justified if volatility remains low and 30-year bonds hold below 3%, Hubner wrote in the letter seen by Bloomberg.
“However, with higher rates and more volatility a distinct possibility, there is a significant risk that asset prices will correct,” he said.
In addition, the downward technical pressure on the Cboe Volatility Index, or VIX, due to the growth of strategies that bet against market volatility, and lower correlations within the S&P 500, shouldn’t be confused with unshakable economic calm, Hubner said.
“While the fear of missing out may not be a concern for equity investors, increasing euphoria mixed with a bit of complacency certainly is,” he said. “Historically low levels of volatility may well have given investors a false sense of security in the nearly two years since the last market correction.”
Hubner also cited the flattening of the yield curve as a cause for concern and said there are technical pressures on Treasuries that may further weigh on bond prices.
“Who is going to buy the paper the Federal Reserve accumulated during the years of quantitative easing? If the Chinese reassess their appetite for U.S. debt, rates will have to move up to finance the projected $700 billion U.S. deficit this year,” he said.
The firm’s Renaissance Institutional Equities Fund, known as RIEF, returned 15 percent last year, according to the letter, as the S&P 500 Index gained 19 percent. Jonathan Gasthalter, a spokesman for East Setauket, New York-based Renaissance, declined to comment.
Former military code-breaker Jim Simons founded Renaissance in the 1980s and ceded control of the firm to Peter Brown and Robert Mercer eight years ago. Mercer stepped down from his role as co-chief executive officer as of Jan. 1 on Simons’s suggestion, after concern that Mercer’s backing of Stephen Bannon and Breitbart News had hurt morale at the firm.
Hubner also wrote in the letter that while equity prices have moved upward for many years, and technical and quantitative analysts say “trend is your friend,” at some point trends reverse.
“While we cannot know when that will happen with the current markets, we are doing our best to prepare for what may be turbulence ahead,” he wrote.