The tremendous volatility in recent weeks has befuddled and confused a lot of traders. There are a lot of benign explanations for it, but today I would like to throw one at you that is a bit more austere.
We may be witnessing the effects of major large hedge funds and other large institutional funds fleeing the scene as rapidly as they possibly can now that they have come to grips with the fact that leverage, or borrowing, levels are going to be impaired for many months, if not years to come. In this explanation, they are both cutting leverage levels from, say, 10 to 1 down to 1:1, and then selling the 1 as well. Because nothing on this scale ever happened before, since high-leverage derivatives are fairly new, there may be nothing in the historical record to prepare us for what it means.
If there is a sudden recognition of this exodus among the public that coincides with a major economic or market event—such as might arrive this week with $360 billion to pay off on Lehman Brothers credit default swaps coming due this week—we could find ourselves in the trap-door scenario.
Yeah, it’s scary. You see, the volatility we’re seeing may be the attempt by remaining players, who must be at least moderately bullish, to absorb the exiting funds’ distribution as quickly as they can. But they are obviously being overwhelmed by the supply of stock dumped on the market, or we would already be seeing at least a consolidation, or a base being built, if not an actual advance.
We’ve talked a lot in the past about the scale of the leverage, or borrowing, used in the past 10 years, but let’s go over it again in this context. You start with one wealthy person, Mr. Big, who was bullish in 2004. He borrows a modest 50% of the value of the $1 million he wants to invest and puts the $1.5 million with a wealth management advisor. They put his money in a fund that invests in hedge funds, which is called a fund of funds, or FOF.
The FOF believes it is investing in low-risk, hedged strategies aimed at 7% annual growth, so it feels comfortable borrowing 2:1 when it puts money with various funds. The funds themselves believe that they are following low-risk strategies that are fully hedged, so they then borrow 5 to 10 times their asset value. So now Mr. Big’s $1 million has magically turned into a $30 million bet by 2007 that all parties believe is fully hedged.
Now fast forward to 2008, and suddenly the hedge funds discover that their hedges haven’t worked so well. They were long energy stocks and short financial stocks because that was the big trend for two years; or they were long emerging market stocks and short G7market stocks in a "decoupling" trade; or they were long distressed debt like Lehman Brothers bonds because they believed the government wouldn’t let such a primary dealer fail; or they were long credit default swaps (CDS), a type of speculative insurance, on Bear Stearns or Fannie Mae debt because they believed the debt would default and they’d get huge payoffs; or they borrowed in cheap yen and invested in rich Icelandic krona.
Most of these very popular trades have met with ruin due to a variety of factors, including world economic conditions worsening at a faster rate than managers expected (killing the G7/EM decoupling trade); surprise in the deterioration of energy (oil prices down 47% in 4 months); surprise government intervention (financial short-selling ban); surprise government non-intervention (Lehman allowed to fail); surprise in the way that CDS insurance has failed to pay off (the non-bankruptcies of Fannie Mae and Bear Stearns); or simply due to the natural forces of overcrowding (too many funds doing the same trade) and entropy (tendency of orderly systems to disintegrate).
Mr. Big Despairs
Now back to Mr. Big. He made good money with his $1 million investment from 2004 to 2007, but it doesn’t take much deterioration for a highly leveraged bet to turn sour. He may have been up as much as 100% at one point, but may now be down 10% or more, so he tries to get his money out. Yet the hedge funds have lock-ups preventing rapid withdrawals, as do the fund of funds. Meanwhile, the wealth manager does all it can to persuade Mr. Big to stay invested "for the long haul," and yet their relationship is ripped apart once real losses emerge, margin calls are made, and initial rounds of new collateral are vaporized as fast as the first rounds. Mr. Big really wants out now.
Keep in mind that leverage is fake money on the way up (you just press a button) but it’s real money on the way down (you must put up or sell real assets to pay off the request for more collateral). This is not an easy task, physically or psychologically. And yet as even some of the hedge funds with the best records have suffered losses of 40% or more in recent months, the process of selling stuff to make margin calls has accelerated. And that acceleration feeds upon itself—an event that is showing up in the incredible rise in the VIX and the decline of many of the hedge funds’ favorite assets, such as Google and Apple shares, crude oil futures and energy stocks.
To see this process in the chart of a single stock, take a look at natural gas exploration hotshot Chesapeake (CHK). Its chairman and co-founder’s decision to repeatedly buy shares on the way up was always a matter of much surprise as it was hard to understand where all the money was coming from. Well, now we know: He was borrowing it. And when gas prices began to falter, CHK shares began to crash, a process exacerbated by the need of chief Aubrey McClendon to sell his borrowed stock to meet margin calls. The shares only found firmer ground in the past week once his broker forced the sale of all his shares.
CHK shares were down 78% from high to low so far, which is actually fairly mild compared to what happened to many of the tech stocks during the Nasdaq crash of 2000-2002. Some of the top tech of that era, such as Broadcom (BRCM), Nortel (NT) and Sun Microsystems (JAVA), initially fell 80%, then paused, and are still down 95% from their 2000 highs. Even mighty Cisco Systems (CSCO) is still down 75% from its bull market high.
Now where does this leave Mr. Big? He may not have wanted out of the FOF when his 100% three-year gain receded into a 50% gain; and he may have been upset when it hit the flat line; but when it goes negative, he wants out, and in a hurry, just like your average Joe the Plumber might feel with his $25,000 stake in mutual funds. So right now he is in the process of trying to exit his FOF commitment, and the FOFs are trying to end their hedge fund commitments; and all of that fake money is turning into a real-money bonfire.
So this is where we are: The "bottoming formation" crowd, headed by some smart-money types, such as Warren Buffett, have apparently decided that Mr. Big and the funds have reached their maximum pain point already and it is time to take assets off their hands in the fire sale. The view was epitomized by a piece Buffett published on the New York Times op-ed page titled, "Buy American. I am." In the column, he reiterated his famous phrase that it pays to be greedy when others are fearful and fearful when others are greedy. The Fed and European Central Bank are literally pouring money into the market, and eventually it should matter. If Buffett and his like are right, they will make bank, as the poker players say.
It has rarely paid to fade Mr. Buffett, as no one has matched his long-term investing record. Yet at the same time, as we have discussed many times before, this is a market that has been incredibly harsh on smart money who thought the worst was already over, ranging from the British billionaire who saw a$500 million bet on Bear Stearns at $100 go bust; the Texas billionaire who lost a $7 billion bet on Washington Mutual at $10; the value mutual funds at John Hancock, Fidelity and Legg Mason which made big bets early in the year on Fannie Mae, Lehman Brothers, Countrywide and Wachovia, and have been crushed with losses of more than 45% this year; and brokerage and energy company chiefs who were crushed by holding companies they understood better than anyone.
In summary, the gauntlet thrown down by Warren Buffett shows us that this really is Showtime at the Apollo, a phrase I have probably used too many times. But I mean it this time. Either we are going to discover that the excesses of leverage were so great that even Mr. Buffett has not recognized how dramatically the game has changed, or we are on the doorstep of a bottom that will rank in history with the greats in the past, such as December 1974, December 1987, November 1990 and December 1994.
As you can probably tell, I lean more toward the skeptical view, in part framed by history books that show how optimism was systematically crushed following the 1929 Crash: In 1929, the "dumb money" lost big. In 1930, the "smart money" lost big. In 1931, the "really smart money" lost big. And in 1932, the "really, really smart money" finally lost big before the market finally turned around in a meaningful way later that year.
My recommendation: Since the best-case scenario would unfold slowly and the worst-case scenario would unfold quickly, I continue to believe your best course is to tread lightly. Prepare mentally for continued high volatility and keep a ton of cash—at least 60% to 75% or more of your investable funds. You do not need to be all macho and follow Warren Buffett into calling a bottom. Even if it has already occurred, because of worsening earnings and continued deleveraging, poor conditions will linger. If you don’t wish to trade and can’t stomach the churning, wait until the coast is clear to put more money at work, which would require a drive by buyers to push the S&P 500 up above 1,200 for at least a week, and for the greatest comfort, above 1,300.
Read Trader’s Advantage to learn about ways to benefit in either scenario.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.
