Two warnings signs that investors ignore at their peril

Most fund managers ignored the warning signs and lost money in the Amaranth debacle. Right now, says John Stepek, the same thing is happening in the broader economy. What alarm bells are the markets refusing to listen to?

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We wrote yesterday about how markets are happily ignoring risks that we believe they should be paying more attention to (see: Do we really live in a perfect world?)

Now some might think this is just us being overly pessimistic. After all, isn't the market the best judge of these things? Doesn't the weight of all those investors' opinions thrown together result in what is broadly a fair value for most investments?

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You might think. But the truth is, as always, far more complicated. Even the experts will happily ignore all sorts of concerns in favour of trotting along with the rest of the herd.

Just ask all those terribly clever and well-qualified fund of hedge fund managers who stuck money into Amaranth

The Times reports that "Amaranth Advisors rang so many alarm bells with one sceptical London investment group that it paid extra penalties for a speedy exit last year ahead of the $6.4bn implosion."

The far-sighted group was Fauchier Partners. And it hadn't bought into Amaranth by choice - it "inherited a $30m position in Amaranth last summer when it took over a competitor, took one look at the hedge fund and demanded its clients' money back."

The firm's co-founder Christopher Fawcett has written that his company spotted "11 red flags". While acknowledging that many unexpected things happen in the financial world, he argues that the problems at Amaranth were "anything but unforeseeable".

What were these warning signs? Well, says Mr Fawcett, "Amaranth had just about every characteristic we do not look for in a hedge fund." The fund has "bad risk management and unattractive terms for investors." As well as poor risk controls, he criticised among other things, the fund's over-reliance on one strategy, the high levels of borrowing involved, and the lack of independent verification of returns.

It does make life a bit more uncomfortable for managers from the likes of Goldman Sachs, Morgan Stanley and Credit Suisse, all of whom put their clients' money into Amaranth and have argued that the collapse couldn't have been predicted.

It's not a dissimilar story in the broader economy. There are plenty of warning signs. Two of the biggest are that consumers in the UK and US are massively over-indebted - consumer debt on both sides of the Atlantic is at record levels. And the British and American public as a group are seriously over-reliant on one highly illiquid investment - property - to maintain the health of their household balance sheets.

And yet the markets sail happily on, as content as an overpaid fund manager to ignore the warning bells and listen only to those who argue that were in a Goldilocks economy (not too hot, not too cold) and that everything will be OK.

Of course, we all know what happened to Goldilocks at the end of the story. And if "she gets eaten by the bears" isn't a big enough warning flag for the markets, we're not sure what is.

We wrote about the UK's debt problems in last week's issue (How to survive Britain's debt crisis), while in this week's issue, out today, James Ferguson writes about the implications of an even more serious threat - the collapse in the US housing market. Subscribers can download the latest issue by clicking here: Latest issue

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Turning back to the markets

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As new record highs were reached on Wall Street, the FTSE 100 climbed through the 6,100 mark yesterday to close at 6,121, a 47-point gain and within a hair's breadth of a five-and-a-half year high. Rising gold and copper prices boosted the metals and mining sectors, propelling Rio Tinto and Vedanta to some of the greatest gains of the day. For a full market report, see: London market close

Elsewhere in Europe, stocks also closed higher on the back of US strength. The Paris CAC-40 was 48 points higher at 5,361 and, in Frankfurt, the DAX-30 was 40 points higher at 6,160.

Across the Atlantic, the Dow Jones was boosted by stronger-than-expected earnings from the likes of McDonald's and Costco, and climbed to a fresh record high close of 11,947, a 95-point gain. The Nasdaq was 37 points higher, at 2,346, whilst the S&P 500 closed 12 points higher, at 1,362.

In Asia, the Nikkei gained 167 points to close at 16,536 today as sentiment was helped by the strong performance on Wall Street and good domestic earnings.

Crude oil remained below the $60 mark this morning, last trading at $58.23. Brent spot was at $58.30 in London.

Spot gold briefly rose above $579 this morning, though it slipped lower as Asian stock markets rallied. It last traded at $577.90.

And in London this morning, Britain's largest coal-miner, UK Coal, announced that it is to post a full-year loss. Production will be much less than expected, down to 3.9-4.1 million tonnes from a predicted 4.5 million tonnes due to 'geological issues'. Shares were down by as much as 7p, or 3.2%, in London today.

And our two recommended articles for today...

Why the US is heading for a currency crisis

- America is triply indebted: its government is in debt, its citizens are saddled with $8.7trn-worth of mortgage debt, and the country is running a huge trade deficit. All of which means the US is heading for a currency crisis. And soon. To find out how the US got into this mess, read Doug Casey's article: Why the US is heading for a currency crisis

'Diworsification': the perils of diversifying across asset classes

- Investors buy hedge funds for two reasons: performance and diversification. Yet funds have been letting down investors on both these counts. So are they still worth the money? Niels C Jensen looks at the statistics: How hedge funds are disappointing investors

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.