Stocks have fallen heavily this week as investors reacted with exasperation and distress to a growing number of signs that the U.S. and global economy are slowing dramatically.
The headline problems were a report showing a 1.2% drop in retail sales in September, the biggest plunge in three years; a speech by Federal Reserve Chairman Ben Bernanke in which he said a broad economic recovery would not happen right away; and late-day reports that super-sized hedge fund Citadel Investment Group faced huge margin calls.
Moreover, J.P. Morgan chief Jamie Dimon said following a grim earnings report that the economy was demonstrating "recessionary conditions," and added that "we expect it to stay that way and likely worsen" as "loan losses trend higher."(See also: "Consumer Shock: Spending Takes a Big Turn for the Worse.")
Yet none of this was really news, right? Our main assumption all year has been that we are in a bear market in recession, and therefore we should focus more on preserving capital than on making it. We know that bad things happen in bear markets, including big declines in retail sales, job losses, waning confidence, crime, anger, and wars. So was there anything really new about this so-called news? No.
What’s Really Happening
What was really happening were a few factors: First, investors are pulling money from hedge funds like there is no tomorrow. TrimTabs Investment Research reported that at least $43 billion was pulled from hedge funds in September due to poor performance over the summer, and more is likely being pulled right now.
One industry insider forecast that the hedge fund would shrink by 50% in the coming six months, with half of the vaporization coming from losses and half from withdrawals. A JP Morgan analyst this week forecast that hedge fund outflows could total $150 billion over the next 12 months, which due to leverage could lead to asset sales of $400 billion.
Folks, that is not a little bit of money. That is a ton. And it comes from the organizations that do by far the most trading, and provide liquidity to the rest of the market. Why is this happening?
For one thing, sure, hedge funds made bad decisions with their clients’ money and have frittered it away on bad bets in commodities, energy and credit derivatives. If you read a lot of hedge funds’ letters’ to their investors, you can see a lot of remorse for underestimating the global recession and for overstaying their welcome in oil, gas and mining stocks worldwide. Yet this is not really such a big deal, because there should be a fairly equal number that made successful bets. If you net out the dumb funds with the smart funds, the amount of money in hedge funds should be even.
No, the problem is that government action has upended the playing field for hedge funds, creating losses where there should have been stability. The short-selling ban, for instance, simply killed a lot of funds in September for no fault of their own because their well-honed strategies were destroyed through what amounts to a sort of force majeure.
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To be sure, some funds might have been piling onto weakened banks and pushing them toward ruin through short-selling, but most short-selling was done to hedge out risks taken elsewhere. When the ban on short-selling was pronounced overnight in mid September, it had the effect of changing the rules dramatically not just for the really small number of bad guys but for many good guys as well. It was as if Major League Baseball suddenly banned base stealing during the middle of a pennant race. Teams that were made up mainly of sluggers wouldn’t have minded, but teams built on speed would have been ruined.
If that were all that had changed, maybe the effect would not have been so great. But then came a series of confusing actions from the Fed and the Treasury , as Lehman Brothers was allowed to go bankrupt even though its smaller rival Bear Stearns had been saved; American Insurance Group (AIG) was rescued in a last-minute bailout, while Washington Mutual was ripped into pieces and its bondholders were left out to dry. And then came a series of erratic bank bailout plans, lending facilities, equity injections and misdirection by policy holders that led to total confusion as to the new rules of engagement for credit holders and buyers.
Hedge Funds Exiting the Scene, Killing Liquidity
Most hedge funds are private partnerships, and they make decisions rapidly. I’ve told you for weeks now that one after another of my sources in the industry say that several large funds have simply elected to stop trading for the year, and Wednesday I learned of even more that had taken this route. They are telling me that either they are fed up with being made scapegoats for the economic distress, or that they would exit Wall Street and trade from their offshore accounts through Singapore, London or super-national European "dark" pools where they face less regulatory uncertainty. They don’t mind playing by the rules; they just don’t know what the rules are anymore.
Hedge funds are much more important to the financial ecosystem than you might expect. To understand why, just think about the majority of pension fund and individual investors. They mostly consider themselves buy-and-holders, so there’s not much action day to day except for the ebb and flow that stems from new money being made available monthly from income to 401(k) plans, or disbursed to retirees or to individuals with major life-milestone needs like college or a home.
If there were only these low-level, murmuring trades going on, the volume of the market would be much lower and it would be harder for buyers to find sellers and vice versa. The high-volume trading done by hedge funds provides the liquidity, the juice, to make all our normal transactions work well. So if the Treasury and Fed have succeeded in scaring off the hedge funds, they’ve truly cut off their nose to spite their face. And if the market falls into the abyss as a result, hedge funds’ answer is: Now maybe you appreciate us, but screw it; we’re not coming back.
On top of this now draining of liquidity there is the growing dread among managers of the wealth of high-net worth individuals that a win by Barack Obama in the presidential election will lead to a rollback of the lower capital gains taxes to ordinary income rates. This is not a fear born purely of politics, as many top fund managers, such as George Soros, openly support Obama . It is born almost purely of their fiduciary responsibility to their clients who may have income disbursement needs in the next few years and would prefer to pay 15% in taxes on their sales now rather than 33% or more on their sales later. It’s really easy to see how this is an important factor if you put yourself in their $500 Feragammo loafers. Why pay twice as much for something in six months than today?
These issues will continue to plague the market for some time even if stocks start to consolidate this week. That’s why it pays to trade in an environment like this. To learn how, check out my Trader’s Advantage newsletter.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights like this, visit www.InvestorPlace.com.
