The Vortex of Selling led by a levered, scared hedge fund community

October 15, 2008, 4:48 pm
Four at Four: The Vortex of Selling
Posted by David Gaffen

The two-day respite has ended. After a soaring rally to open the week and a middling Tuesday that at least didn’t turn into a rout, the markets barfed out another horrific session Wednesday, culminating in another one of those late-day swoons that left major indexes not far from their closing levels Friday. The selling was wide and deep, as the brief euphoria in the banking sector was washed down the drain with a 10.7% decline in the Financial Select Sector SPDRs fund, which tracks the S&P 500’s financial sector. Heavy losses were sustained by technology, small-cap stocks, transports, and cyclicals — pretty much everybody on a day when the S&P lost 9% of its value, much of it, again, coming in the final hour. The 7.87% decline in the Dow industrials ranks as the worst since the Oct. 26, 1987 decline, and the S&P 500’s fall is actually the worst since Black Monday in 1987 (Oct. 19). “We continue to see a vortex of selling, led by a levered, scared hedge fund community stepping on each other trying to get in front of the other guy to liquidate, based upon the real investment losses that they’ve experienced, coupled with the threat of year-end redemptions,” says Doug Kass, president of Seabreeze Partners. This time, economic fears were responsible for the market’s early declines, and those fears multiplied through the session.


Just do what I want, ok?
The decline, in part, can be linked to the recognition that things are still ugly in credit markets, despite the government’s demand that the largest banks accept $250 billion in credit, along with a few other conditions. Regardless of the capital infusion, banks may still not want to lend money — to each other or corporate borrowers – and they can’t be forced to do so. What’s more, after this binge of debt fueled by lower-than-necessary interest rates, lending may not be the solution now anyway. “It is in no one’s best interest to lend that much money,” writes Mike Shedlock of Sitka Pacific Capital Management, on his blog. “We are in this mess because banks lent money to anyone and everyone including those with no possible means of paying the money back.” Three-month LIBOR rates have started to decline — hitting 4.55% overnight — but the three-month Treasury bill was of late trading at 0.21%, putting the TED spread, a key indicator of market stress, at 3.34 percentage points, not much better than at the beginning of the week. Meanwhile, due to the need for safe credit, the repo markets have become strained — some participants reported not being able to find enough Treasurys in the repo market.

Fear remains the driving emotion, as J.P. Morgan Chase & Co. CEO Jamie Dimon explained on the firm’s conference call following its earnings report. Meredith Whitney of Oppenheimer asked Mr. Dimon about self-fulfilling prophecies — situations where, if a bank pulls back from offering credit, others will follow, causing more deterioration, causing a further pullback. Mr. Dimon didn’t disagree, saying that if “everyone pulls credit out of California, obviously it will accelerate the depreciation of homes in California and make it harder to — scarier for people to provide credit.” He notes that the government is trying to reverse this trend, and that “you start to see some beneficial effect of that in the next couple weeks.” Ms. Whitney told him that if he believed that, they’d be taking on more risky assets, and while Mr. Dimon said they’re buying “slightly more risky assets,” but added, “if you are not fearful, you’re crazy.” To which Ms. Whitney said, “I’m fearful.” Mr. Dimon responded: “We know you are. We’re waiting for you to reverse your position.”

The Nasdaq Composite and the Russell 2000 react to economic fears more quickly than other areas, and their weakness relative to the broad market this week continues to be a bad sign for the economic outlook. Those indexes have underperformed the rest of the market since mid-September, and the consumer tech stocks have taken it hard in particular. “Nasdaq has got an awful lot of consumer-discretionary stocks…the Apples, the Research In Motions, even the personal-computer manufacturers…so much of that can be cut back on by consumers,” said Frank Beck, chief investment officer of Capital Financial Group. Putting it more bluntly, Dave Rovelli, head of trading at Canaccord Adams, says he’s “never seen technology trade this poorly — the small-cap techs have no bid to them.” The principal reason for the relative weakness is that concerns this week have shifted from the imminent failure of banks - something that hurt financial stocks on the DJIA and S&P 500 - to the repercussions of the credit crunch for economies worldwide. Marc Roberts, director of research and technical analysis at Direct Access Partners, says the Russell 2000 could test the lower end of its Friday range, which was at 468. (It fell through the upper end to close at 502.11 Wednesday.) –Rob Curran