Bigger Guns, More Ammo

Ok, now the “market” has really hit a new low.

I had characterized the November 20th low as the “near collapse of the global financial system” low, and due to the extreme readings of fear and concern at that time (VIX flew to 80, bond spreads widened to historic highs, etc.) I had felt that a retest was unlikely. I was wrong.

This latest new low could be labeled as the “near nationalization of the US banking industry,” but somehow I feel that concern over the banking sector is not the whole story. Even smart people like Barron’s Michael Santoli, who I respect a great deal, find the market’s action so far this year puzzling. In his latest piece he writes, “Rather than a manic and dramatic dive, the drop since early January has been a monotonous and numbing slouch. The selling has been of lower intensity, less inclusiveness, accompanied far less by panic than resignation.” Despite his accurate assessment of the nature of this part of the decline, he fails to discover the root cause for this trip back to the old lows.

Maybe it’s as simple as hedge fund short selling. Short sellers are able to make money as the price of a stock declines. Hedge funds are well-known for their practice of short selling, often as a “hedge” against other assets they own, but in dramatic times like these, where many are fighting for survival, maybe they are simply only investing on the short side. We learned recently that Paulson & Co., a New York City-based hedge fund, made over $200 million from its short position on Royal Bank of Scotland. Multiply this experience by all the bank stocks feeling pressure times all the hedge funds struggling to prosper in these challenging times, and we may find a root cause of the weakness in the market.

I find it somewhat ironic that the heads of US banks receiving government aid can find themselves at the feet of a government panel being berated for alleged mismanagement during the most extraordinary times, while bank stock-shorting hedge funds escape all scrutiny and press coverage. With the traditional buyers of stock (mutual funds, endowments, individual investors) sitting on $9 trillion in money market assets waiting for a “better time” to buy stocks, it is possible that all this short selling is the driving force for the market right now. Consider too the public outrage that might be generated if investors realized that hedge funds were making tons of money as the market declined. And yet, we hear nothing about them…

For all the positive sentiment heroic stories like the Alamo and the Battle for Thermopylae may engender in our hearts, ultimately these brave souls perished because their enemies had bigger guns and more ammo. Maybe “enemy” is too strong a word to characterize the short-selling hedge funds prospering while our portfolios shrink, but it’s easy for me right now to feel more like the Spartans and less like the Persians.