Jul 29

What’s Next for the Battered Financial Markets? Follow the Money.

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If you owned something and wanted to determine its current value, wouldn’t you look to see where it last traded?

For many financial assets, like most of those held by insurers, you go to the latest quotes from listed markets or from broker/dealers involved in the market.  But, what happens when most of those trades are not being made by longer term investors, like yourself, but by investors with extremely short term horizons.  Yes, it’s the hedge funds who do a large share of the trading and so their collective views on markets tend to shape those prices.

A few views on the influence of hedge funds on trading activity:  It is estimated that nearly 1/4 of all trading on the New York Stock Exchange is done by hedge funds and nearly 1/3 of London Stock Exchange trading is so domniated.  Some have estimated that 3/4 of actively traded convertible bonds, 45% of emerging market bonds, 47%% of distressed debt and 25% of high yield bond trading is done by the hedgies.  As one would expect, in the derivatives markets, hedgie trading domination is even greater: 55% of credit derivatives trading, and a large chunk of interest rate derivaitves.  And, let us not forget that much of cash bond pricing is influenced by all that derivatives trading.

Hedge funds still control asset totals in amounts much less than insurers, pension funds, banks and other traditional institutional investors, but they have a disproportionate control of trading.  That means when they all head for the door, markets shake in the same direction (up or down, depending upon your perspective).  And, a few negative bits of news finally caused the hedgies and their risk models to capitulate on what was a sunny view of credit, the economy, etc.  Those risk models basically say to reduce risk when results start getting shaky and they started getting shaky in a hurry as these big traders started groping for the exits (why does that sound peculiarly like ‘portfolio insurance’ in the late 80s?).  And that has meant rising credit spreads (finally) and more sensitivity to credit in general.

However, let us not forget what economist Paul Samuelson once noted:  “The stock market has predicted nine of the last five recessions.”

And that will most likely be true in this case.  As we’ve been telling our clients for some time:  Don’t expect those equity returns to continue, as long term expected mean returns for US equities are closer to 8%, not what we registered through the beginning of last week.

We’ve been telling our clients for over a year now that residential real estate price weakness (the so called ‘wealth effect’) is not the issue, but the repricing of ARMs (many times resulting in a doubling or more of monthly payments) will cause economic problems.  And that problem impacts all types of borrowers, from ‘A’ credits all way through sub prime, albeit to differing degrees.  We estimate that this phenomenon has about a year and a half to work its way through the system.

The ultimate economic impact of this is still to be fully played out, but at this point, we would side with Dr. Samuelson and add the immortal words of Bette Davis in  ’All About Eve’:  “Fasten your seat belts, it’s going to be a bumpy night!”

Meanwhile, if you want to see where the markets will go next, just follow the money…and that means anticipating to where the hedgies and their risk models will run next.