Interpreting Market Action

A principal mission at "A Dash" is developing a guide for the intelligent individual investor.  (We are eager for more comments and emails from any readers who qualify, since you are the target).  Sometimes our interest intersects with that of more active traders, and this may be one of those times.

Our Current Posture

As we have indicated, our investment posture varies with the time frame.  Since we have different products for different investors, our positions may seem to be at odds.  It is actually quite consistent for those with different time frames to have different perspectives.

The main point is that we have no market bias.  We have different methods for different investors, as we should.  We follow our methods with rigor, always watching changes in our indicators.  We are willing to vary our position according to circumstances,  just as we did in the 2000-01 era for long-term investors.

Drivers of Current Market Action

Looking at the behavior of stocks and sectors over the last two weeks shows a very unusual pattern.  There is certainly a problem, centered in securities related to subprime mortgages, and then  apparently spreading to other mortgage-backed assets.  Many observers (too numerous to cite, but all astute)  have pointed out that the problems are affecting stocks that have absolutely no relationship to the mortgage markets.  Ben Stein’s article in today’s New York Times points this out, and attempts to provide some overall quantification.

Investors should attempt to profit from deviations from the efficient market hypothesis.  If Ben Stein has an accurate read on the overall problem, why is the general market experiencing such selling?  There are two divergent theories:  Economic collapse and hedge fund activity.

Economic Collapse

Regular readers of "A Dash" know that we do not endorse the theory that this is the first of many dominoes leading to a recession.  There is plenty of economic data suggesting that this is not the case.  It is a subject to which we shall return — but not today.

Hedge Fund Activity

There are many quantitative "black box" hedge funds, developed by people with PhD’s, that seek to exploit small differences between two securities.  Some of these strategies involved monthly yields of 30 bps or so — not enough to generate an attractive annual yield.  By convincing banks of the wisdom of these approaches, the funds applied leverage.  This turned the annual yield into rates of 15% to 30%.  For a time, these yields were uncorrelated with the overall equity market.  This was extremely attractive to  investors who bought into the backtesting methods, the debt ratings of mortgage securities from major firms, and the general concept that something with a yield was safe.  We cited James Altucher concerning some of these strategies, showing how the leverage proved fatal to the hedge funds involved.

Ripple Effects

Let us now turn to a different hedge fund strategy.  Suppose the fund buys senior debt and sells junior debt, a process nicely described by John Mauldlin.  (We recommend reading the entire article carefully — twice if necessary.  While Mauldin has been incorrectly bearish for some time, he often shows a strong understanding of relationships in his comments.  We do not agree with his assessment of the time frame for sorting this out, but no one really knows).

Next suppose that the junior debt halts trading, so it cannot be evaluated.  Some hedge funds are selling senior debt, since they face redemptions and margin calls.  The result is that a fund with a sound strategy faces apparent losses based upon current marks.  This is caused not by the fundamental relationship between the securities, but by a loss of liquidity for one of them, a topic covered nicely by Bill Rempel.

Exacerbating the problem is that many funds have a combination of "sound" and unsound strategies.  Facing redemptions and margin calls, the funds are forced to sell what they can.  This includes unwinding many  theoretically good pair trades  of one  stock or sector versus another.

Our observation of stock and sector trading is that many attractive holdings have been caught in this process.  We advised our investors that this was an opportunity, with timing still a bit uncertain.

The End of Hedge Fund Forced Selling?

It may be difficult to spot the exact end of this process.  Goldman Sachs today held a conference call where they stated that the deleveraging was, in their opinion, more than 75% complete and perhaps approaching 100%.  They invested in one of their (losing) funds and brought in new investors to the tune of $3 Bilion.  This was a statement that they preferred to hold on to strong strategies until the relevant markets achieved normalcy.  The market was skeptical, so the end has not yet been reached.

David Merkel has a typically excellent article with many links discussing how far the process has gone, and what future prospects might be.  The conclusions vary, but provide plenty of food for thought.

It is not the end of model-based trading, and there is nothing wrong with having a PhD.  (Some of our best friends have the degree!)  It has more to do with balancing strict mathematics with sound research methods and simulation — something that many of the big-money funds did not do.

Where to Learn?

There is so much conflicting interpretation and advice that it is confusing for the average investor, no matter how smart she is.  There is so much bombastic comment, loaded with symbolic language, that the average intelligent investor may not know where to turn.

The problem of finding good sources of information — analysis as well as anecdotes — is the major challenge for an investor making his own decisions.  An incorrect choice of sources means that a little knowledge can actually be dangerous.

One of our ongoing missions is how to find dependable sources, especially in a multi-year climate where perma-bear blogs regularly hit the top of the ratings charts, even when their forecasts have been quite wrong.

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  • Bill aka NO DooDahs! August 14, 2007  

    Thanks for the link love! No “Piled High and Deep” jokes …
    About temporary liquidity (properly defined as money flowing through a market and not as “money supply” LOL) lapses and “mark to market,” some thoughts.
    Buy and holders of bonds don’t care about the quote or the market for the bond as much as traders do; they’re in it for the yield. Now, the auditor is gonna want the company to get a bid on inventory every once in a while, and will appreciate if they go out and hit the bid a few times a year, but otherwise, they want yield.
    Some hedgies playing the yield game may recognize the mark to market in a low-liquidity sitchooayshun will result in paper losses for the fund. When a market returns for the bonds, the mark to market will be UP. So what to do?
    That hedgie might choose to recapitalize the fund until such time as the market returns to normalcy.
    Does this sound … familiar?

  • Aaron August 16, 2007  

    Very interesting article. I completely agree that the perma-bear sites are out in full force now with all of their end of the world economic insight projections. In this market, a lot of people seem to listen to them too. I agree that a recession is less likely than most believe.

  • Maybe we could link up some of our blog content to provide more comprehensive information on hedge funds for investors? If you want to chat my email is
    – R