Bandwagon jumping Hedge Monkeys: how a new species of simian explained the market to me
You guys know me as a guy who does ok at stock picking, writes an ok blog, made a great call on financials a year ago, and a so-far bad (and very poorly timed in any case) call on a small cap airline late last year (RJET). What you probably didn't know about me is that in my spare time i am a wildlife explorer. Just this morning I hopped a plane to Africa and ran out into the bush and discovered a brand new species of monkey.
Its a really interesting species of monkey, its primary characteristic is spends part of its time standing around looking everywhere, apparently not sure what to do, and the other part of its rime rushing in giant packs all in the same direction to do the same thing. So dramatic is the tendency of these apes to follow each other that as I stood there observing them, the entire clan ran directly into a tree, in fact into the exact same tree, and each of them suffered bruises and facial scrapes as a result. At another point in the day a baby monkey started crying, which led to its mother crying, which led to the entire pack crying and sobbing hysterically. Half an hour later they were all laughing and dancing. What one monkey does, the rest of the monkeys soon do as well. Its not clear how this "all monkeys do the same thing" phenomenon begins, that will require further study, but once a trend in the pack begins it becomes universal in minutes.
It lives in small hedges, which provide it fruit (in fact 2% of the weight of those hedges are berries and in a good year with alot of rain the hedges can convert 20% of the weight of rainfall into more berries). To my considerable amazement, these monkeys can speak english, follow wall street, and have an extremely interesting outlook on the financial markets. Its not clear at this time how they get their stock quotes, as I couldn't find anycomputers or blackberries laying around, but somehow they do.
In talking with the pack of Hedge Monkeys, I learned a few things. As I myself am fairly new to wall street, and am still learning the tricks of the trade and the facets of the marketplace, this was quite informative.
One monkey pointed out that, on wall street, people don't like to short stocks into an uptrend. Rather, they like to short stocks once a downtrend has established itself. The monkey suggested that I start reading iBankCoin a bit, because its fairly funny and its interesting to read the thoughts of The Fly and the other contributors. A common theme on that site, says the monkey, is that one should not short stocks until the market shows weakness.
The monkey also said that I'm a fool if I have not been reading RealMoney Silver over at thestreet.com. He says that same advice is constantly given. Constantly. By chartists and TA guys it is UNIVERSAL: buy stocks moving up, sell stocks moving down. By Rev Shark and Cramer (two guys who seem to have some significant momentum investing talents). Few people there, Doug Kass being an exception, along with a cuople of deep value guys (Melvin and more) seem to like stocks more as they crash. Most of them, the monkey pointed out, are momentum guys who short stocks with "established downtrends" and buy stocks with "established uptrends".
And, the monkey points out, there is good sense to this. Shorting stocks into an uptrend is wildly risky. Witness, the monkey points out, the incredible pain suffered by many caps game players shorting stocks in 2009 and predicting a crash or the end of the uptrend.
Markets, the monkey said, quoting Keynes himself, can remain what you consider "irrational" alot longer than you would like them to. So, the monkey noted, trend following tends to be a rewarding manner of investing.
From there, the monkey observed that once a trend is begun and many people are following it, it tends to go alot farther than is reasonable, at least sometimes. The traders then get ready to head for the exits at the first sign of weakness. Follow the trend, but once its over get out quick.
This tends to create a new trend: a down trend.
The monkey then ran off, screaming and flailing his arms into the air, only to smash his face directly into a tree. He came back, bleeding a little bit, and gave me his hypothesis on the markets over the last 2 years.
In 2008, the monkey observed that many stocks had fallen out of favor due to high valuations and problems with real estate and banks. However, commodities had been in a general uptrend since 2000... So the traders all piled into the thing with the uptrend (commodities) and piled out of the things with downtrends (everything else). This resulted in an extraordinary run into a bubble for basically everything commodity related. One day the party ended and stuff started crashing, then panic hit the system, commodity stocks like everything else entered a downtrend and the traders ran for the exits.
The downtrend was so strong in early 2009 that the traders all started selling and selling and selling until, said my new monkey friend, wall street had hit an all time (by far) record level of short interest at the bottom in 2009. Short selling from mid-february to early march was like free money, the monkey observed. Then Vikram Pandit authored that memo, which scared a few traders into covering. This created more covering until eventualy an uptrend was established and traders began piling into that uptrend.
I was curious at htis monkeys take on it all, and was about to ask him a question when one monkey started laughing and barking and dancing. Soon my monkey friend joined him, dancing and laughing and barking away. An hour later when the pack settled down I found him again and asked my question:
"But, dear monkey, Charles Biderman of TrimTabs research has said that to move the S&P from below 670 to over 1100 would require 100's of billions of dollars, probably 500-800 billion dollars of new money coming in. Yet equity mutual funds had outflows in 2009, not inflows, so where could the money come from? Isn't there some kind of conspiracy or something?"
The monkey replied "no, you foolish human, its simple. The hedge fund industry has more than $1 trillion under management (the monkey estimated about $1.5 trillion) and operates with typically 25% leverage (75% long, 50% short, ratios subject to variance)".
He continued "that means that the hedgies control more than $2 trillion. At the market bottom in 2009 Doug Kass at RealMoney silver said that the hedge fund industry was at record levels of short interest, the mutual fund industry at record levels of cash. Indeed, the market itself was at record levels of short interest, plus, probably, vast quantities of additional naked short interest that can't be tracked. If the hedge funds were 50/50 long/short then and 60/40 long/short now that alonewould provide $400 billion of "buying", if the hedgies were net short at the bottom, which the monkey thought they were, a move from 60/40 net short to 60/40 net long would result in $800 billion of net buying. Cover $400 billion, buy $400 billion"
"Throw in", the monkey continued, "mutual funds lowering cash levels and increasing long exposure and even some reblaancing from pension funds and there you have it: more than enough money to raise the S&P by 70% per Bidermans thesis"
The monkey then ran off to get involved in a poo-flinging contest with the rest of the pack.
I realized I was going to miss my flight home to my couch if I didn't take off, so I headed out. I wonder if I will ever see those hedge-dwelling, bandwagon-hopping, trend-following monkeys again? I wonder if the scientific community will credit me with their discovery?
On the flight home I thought about what the monkey had said and... I came to hold this hypothetical structure of the last few years as reasonable:
-hedge funds got huge early in the last decade. While mutual funds were blowing up in the crash, they, ever trend-following as they are, rode it down and made money or broke even while long-only suffered.
-the repeated preposterous valuations in various asset classes throughout the '00s was the result of this massive amount of hedge fund money (and probably mutual fund money also) chasing trends. Trend chasing is what chartists do, its what seems to be the most common tactic among pro's from my reading on the 'web and listenign to discussions. Witness preposterous bubbles in casino stocks, in REITs, in commodities and commodity stocks, and the just generally retarded valuations that existed at the top in 2007. Hedgies were record long, mutual funds had record low cash. One trend and bubble just flowed into another as the first one popped. Out of real estate into commodities... Out of commodities into shorting after lehman, out of shorting into long after Vikram's memo and the march bottom.
-Simple rebalancing at hedge funds probably provided enough money to move the market this far. Simply covering shorts and increasing net long positions probably was enough to get us here. At the bottom RCL had 30 some percent short interest, lol. DIN had 30 some percent (still high 20's a while ago), ASH, ACAS, XL, YOU NAME IT, all of the stocks that I owned had massive, massive short interest. All last year bears cried and whined and pouted about how "trash" stocks were moving up the most, not quality stocks. I simply suggest that massive waves of short covering (from massive, massive, record levels) in everything that was out of favor at the bottom (when the momentum following nature of hedge funds was maximally short the maximally out of favor names).
This shorting whats not in favor / covering into any uptrend explains the wild, runaway, wanton volatility in all of the "out of favor atht ebottom" names. It explains it in casinos (MGM down to $1.xx, up to $12.xx, down to $5.xx, up to $14.xx), financials, consumer discretionaries, cyclicals, the works.
-The market keeps moving up, by and large, because plain and simple this rally is so hated, so reviled, and so a product of short covering into low volume -vs- bargain hunters stepping in that alot of people are still on the sidelines. Eventually they semi-capitulate and pile into momentum stocks to try to make a few bucks.
-we have one more round of "the trade coming off" in commodities before this is all over. ... A great many commodities are currently seeing prices propped by the massive pack of bipolr momenum-following hedge monkeys that is wall street and the hedge industry. I think some point where many commodity prices are substantially lower than today is probable.
-I don't think too many people make much money selling short, including the hedge-monkey industry. I think its far easier to make money long, and I think in general this fact combined with the fact that the hedgies are basically at heart just interested in making money ... will provide buoyancy to the market.
-I think the presence of the hedge fund industry in all of its trend-following glory will tend to increase market volatility and lead to increasing bubble/bust behavior. The hedgies will blow up bubbles to make money long, and when a crash really sets in they will pile in to short only if the trend is clearly established. THEY MAKE MORE BEING LONG, ... ,
Frankly, I think the next 3-8 years will see one more cahnce to poke at an actual, real asset bubble (stocks right now are hardly at bubble valuations) and one mor chance to buy actually cheap (stocks right now are hardly in bargain basement territory). And a whole lot of actionable trend changes and buyable dips in between.
The rise of the bipolar hedge monkeys may explain a great deal of the markets insanity over the last 8 years ... and we may not be done with that insanity. And I doubt that the market crashes soon.
The bipolar hedge monkeys rebalancing from net long to neutral or net long to net short or net short to net long is enough to, apparently, per bidermans estimates, cause monstrous swings in the market.
The low volume is becaue mutual funds don't have that much $$$ to work with as its still flowing out, and individuals are sidelined and playing with bond funds...