Stock price rally will last when distress dumping ends
By Neil Behrmann
December 2008:- Hope usually springs eternal on global markets, but those hopes have swiftly turned to despair as distressed selling has persisted. At last, however, there are signs that the dumping of stocks appears to be reaching a climax. The hope is that the nastiest global bear market since the early seventies may either experience a sizeable lasting rally which will presage a bottoming out process. The danger is the fall out from the unravelling of the Ponzi scheme of Bernard Madoff. According to rumours swilling around Wall Street and London up to $50 billion has been lost. On Friday December 12, markets began to fall again on expectations that there would be liquidation from asset managers and other investors who gave him money.
During the past few months investors and traders have bit their nails as they waited for the dreaded final hour before the daily Wall Street close. Time after time rallies would be snuffed out by a wave of selling in the final minutes of the market’s closure, leading to declines in Asia and Europe. Sometimes the market would suddenly shoot up at the close, only to be followed by steep slides a few days later. Fingers point towards the usual suspects, notably hedge funds. To be fair, however, mutual funds facing massive redemptions have also been offloading stocks. Issuers of structured equity products which offer their investors guarantees that their capital will remain intact, sold to limit their losses. Finally disenchanted pension fund managers and individuals have taken fright and offloaded shares.
The main sellers in recent weeks and months, however, have been hedge funds, according to equity traders. Short sellers, however, were not to blame. Instead hedge fund bull positions have been dumped. Hedge funds are leveraged i.e. they borrowed to buy or sell shares, bonds and commodities. At its peak last year investors had around $1.8 trillion in hedge funds. On average, according to people in the business, the leverage was around 2.5 times. On this estimate about $4.5 trillion of hedge fund money was committed to financial markets. That was fine when the going was good and investors were piling into the funds. But Hedge Fund Research’s HFRX index, an indicator of average hedge fund returns, tumbled by 22 percent in the year to the end of November. This sorry performance discouraged investors who bought hedge funds on the grounds that they should do well in bear markets. They have thus been queuing up to withdraw their money.
In recent weeks the market has kept bouncing off the bottom of around 800 points on the S&P 500 Index. The oversold market has begun another rally. The question now is whether distress selling in January will scuttle the revival of Wall Street and other global markets.
Within the confines of the super rich secretive hedge fund community, panic ensued. A simple example explains why. Say investors want to redeem $100 million from a hedge fund manager. Their $100 million previously purchased $250 million of shares which the manager must now sell in the downturn. To make matters worse, the hedge fund managers’ “prime brokers”, notably the big investment banks that lend them money, tightened the screws when they observed that their clients were faring poorly. They put pressure on the fund managers to deleverage in other words slash their borrowings. This left them no alternative but to sell. Moreover, growing numbers of hedge funds have decided to freeze withdrawals, telling their investors that it is best to wait for repayment, otherwise their investments would shrink to almost zero. This has made investors even more concerned and the frantic queues for withdrawals have lengthened.
Distress selling tailing off
Hardly surprising every market rally was a relief for these distressed managers who used the opportunities to get out. They sold to investors who thought they were buying bargains, only to find that the prices of their so called bargains fell even further. Fortunately a glimmer of light can be seen in the market gloom. A Goldman Sachs report indicates that the wave of hedge fund stock liquidations could diminish in coming months. Based on 705 major hedge funds’ filings to the US Securities & Exchange Commission, hedge funds’ long (bull) equity positions on US markets fell from $1 trillion in June 2007 to $896 billion in June before dropping to $616 billion at the end of September. In contrast, short positions have been relatively constant around $500 billion to $600 billion. As a result, hedge fund net exposure to the US equity market during this period fell by 77 percent from $456 billion to only $103 billion. Hedge funds appear to have net long exposure of just 17% compared with 47% one year ago, signalling greater risk aversion, observes Goldman Sachs. Hedge fund ownership of the Russell 3000 Index of the largest and most liquid US stocks fell to 3.5% from 4.5% during the course of the third quarter of 2008. Anecdotal reports indicate that in October and the first three weeks of November, hedge fund holdings continued to shrink.
Statistics on European and Asian markets are unavailable, but there has been hedge fund distress selling there as well. Once the selling slows to a trickle, markets should become less volatile, true long term investors should return, raising hopes of an end to the bear market.
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