How will markets cope when the cheap money is taken away?

Billionaire investor Carl Icahn is returning his investors' money.

The activist shareholder has said that he's going to give back the money that outside investors have in his $7bn hedge funds because he doesn't want the responsibility of looking after it through another downturn.

Now, Icahn isn't exactly warning that the market is heading for another slump. He's still investing his own money, and there are plenty of good reasons for him to stop managing other people's money, which we'll go into below.

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But he could certainly be forgiven for feeling that after such a good run, it might be time to quit while he's ahead

Why is Carl Icahn giving back his investors' money?

"Given the rapid market run-up over the past two years and our ongoing concerns about the economic outlook, and recent political tensions in the Middle East, I do not wish to be responsible to limited partners through another possible market crisis".

That's how Carl Icahn told investors that he's giving them back their money. He's not the first hedge fund manager to do so. And you can see why he's doing it. For one thing, he's 75 who needs the hassle? As an old hand, he can take the pressure of volatile markets. But it's no fun watching your more fragile partners screaming to get their money back at the first whiff of panic.

And of course, markets have had a good run. No doubt he feels that it's a better to exit on a high note. It's not as if he's quitting managing money altogether it's just other people's money that he doesn't want to be responsible for.

But there are good reasons to be nervy. The stock market rally is two years old now. It's been through plenty of blips, most prominently the eurozone crisis last year. But it's managed to come through.

The bull case versus the bear case

Will it continue? As James Mackintosh points out in his Financial Times column this morning, there are two scenarios from history one bullish, the other bearish. On the bullish front, there's 1987. After that crash, it took two and half years about the same period as now for the S&P 500 to recover to where it was before the plunge, says Mackintosh. But then stocks continued higher. The economy was rallying, and shares didn't look especially expensive.

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The bear case compares today to the 1970s, when after the crash of 1973/74, stocks traded sideways for years. Now, as then, we have "soaring oil prices; the risk of governments choosing to inflate away their debts; and excessively easy money".

It's all about the cheap money or lack of it

So which is the better comparison? To my mind, the problem just now boils down to monetary policy. We're at a point where central banks would have to get very radical indeed to make monetary policy any looser. Even various members of the Federal Reserve, which is traditionally a much more consensual central bank than our own Bank of England, are speaking out against the idea of another bout of quantitative easing. Ben Bernanke might have his finger hovering over the 'print' button, but it's possible he won't get his way.

More to the point, any move to loosen monetary policy further would just fuel inflation. You can argue until you're blue in the face about whether quantitative easing (QE) has boosted inflation or not. But I think you just need to look at the chart on my colleagueMerryn Somerset Webb's blog on this point to see that regardless of the mechanics of it asset prices have reacted very strongly to QE over the past couple of years.

The problem is that once inflation gets to the point where it's clearly getting out of control (probably around the mid-to-high single digit point), then it's bad news for most asset prices. That's probably because central banks are then forced to raise interest rates to combat it.

In short, much of the rally has been fuelled by cheap money. With the Fed ending QE2 in June, pressure on both the Bank of England and European Central Bank to raise rates, and even developing markets trying to crack down on easy credit, it's hard to see where the market will get the extra rocket fuel to keep heading higher.

Meanwhile, Europe's woes aren't going away. Portuguese bond yields are heading higher again, and Greece is back on the radar. And of course, there's the Middle Eastern turmoil hanging over everything.

We'll be looking at the outlook for the US economy specifically after all, it's still the most important economy in the world in the next issue of MoneyWeek, out on Friday. If you're not already a subscriber, subscribe to MoneyWeek magazine. But suffice to say, whatever Mr Icahn's specific reasons for handing back his investors' money, I doubt he'll regret the timing.

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