Tuesday, 22 January 2008

Economics Strikes Back: Revenge of the [Hedge] Funds

Today, Tuesday 22 January, has seen wide-magnitude fluctuations on European stock exchanges, triggered in part due to larger drops in Asian overnight trading. Much of today's volatility (as I write, exchanges are still open) is probably attributed to computer batch trades, driven by pre-set sell/buy triggers (usually stock sales volumes and price benchmarks). The Washington Post reports that the S&P is expected to decline by 4.5% once trading starts today (US exchanges were closed yesterday due to Martin Luther King day).

I have no doubt that this will be a rough and exciting week. The fundamentals, however, are clear: certain benchmark stocks in the Dow Jones and S&P indeces are overvalued, and have been for years. Residential real estate is equally overvalued.It's time for a correction.

Much of US corporate profitability in recent years has been due to creative financial engineering and one-off gifts: the dollar's decline, tax breaks on repatriation of overseas income, etc. In contrast, order-of-magnitude changes to profitability, such as IT-driven productivity, lean manufacturing and outsourcing, are reaching the end of their run. Gravity is re-asserting itself: overseas competition and commoditisation is growing; WTO allows great access of merchandise imports into the US; other factors are contributing to the declining relative competitiveness of US enterprises.

We should, therefore, welcome a correction. Massaging interest rates to stimulate consumer or corporate spending will not work: the negative personal savings rate has for years been sustained by re-mortgaging during the real estate boom. Today, this tactic no longer works: lower interest rates today lead to higher credit debt, not higher property prices. Corporate opportunities for investment are therefore even less attractive, particularly given the consumer slow-down, property market collapse, and stock market turmoil.

A correction could easily last for 3 or 4 quarters, making this one of the longest in recent memory. I have no predictions for the depth of the slow-down, for reasons I will explain in the next paragraph.

The main threat I see at present (remember, this is Tuesday 22/01/2008 at 14:00 local time) is the impact of the recent stock market fall on hedge funds and the derivatives market. We have no visibility on the size of this market, which probably amounts to over $ 500 trillion at the end of 2007. Many contracts are pegged to relatively shallow stock or commodity price movements. We are currently in an extremely volatile situation, where I believe the magnitude of stock and commodity movements are much higher, perhaps with a magnitude of +/- 10-25% over a single trading session.

This magnitude may have a catastrophic impact on derivatives contracts. We face a critical lack of visibility brought on by securitisation, the absurdly high leverage ratio of most hedge funds, and the fact that there is no central, real-time registry of swaps or trades. The situation is much much worse than the sub-prime market. The failure of only a small number of funds could herald a system melt-down.

I believe this is what accounts for the unusual volatility among institutional trading today and last week. The sub-prime failure (together with the impending ALT-A failure) is only the tip of the iceberg. It is not, in my humble opinion, enough to account for the institutional panic we see right now.

The elephant in the room that no one is talking about is the fear of what might happen should another Long Term Capital Management - or two or ten - fail this week, or next.

Let's hope the storm passes without mishap. But then it will be back to business as usual, leaving the final reckoning for another day.

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