Hedge Fund Deleveraging Likely to Continue

Banks are continuing to ask for more collateral to back past hedge fund lending, causing more funds to liquidate their positions (see WSJ article). When added with investor redemption, bank-induced liquidation is forcing hedge funds to step-up their deleveraging.

Such selling is continuing to put pressure on the market, generating more requests for bank collateral and investor redemption, in what amounts to a catch-22 that continues to spiral the market downward. Such selling has been occurring for a while, as funds have been unwinding exposure to financial and energy stocks, both of which continue to suffer as crude oil continues to drop, and the credit crisis continues to unfold.

While Hedge Fund Research recently reported that the level of hedge fund market exposure has decreased by one-third over the last year, I suspect that this still may not be enough. As mentioned by Antonio Munoz-Sune, head of the U.S. for fund of funds EIM: "The combination can take anyone down."

Unfortunately, it is difficult to tell where we are in the hedge fund closing and deleveraging process, with many hedge funds still appearing to use every rally as an opportunity to sell. I suspect that until we see the VIX approach more normal sub-30 levels, stop seeing the DJIA and S&P 500 Index post intra-day percent swings in the high single digits, and see crude oil stop falling in price, it is unlikely that the market will stop feeling the effects of hedge fund selling, allowing for a long-term and lasting rally.

Like most bottoms, we won't know for sure that it has occurred until we see it in the rear-view mirror, but I will be watching the VIX, the price of crude oil, and the Dow Jones and S&P 500 index percent swings for clues.

Comments

[investor88:]

Prof Enke has written a short but most useful article. In trying to find direction in the markets, we need to focus on some of the major players and we cannot take our eyes off the hedge funds! Prof Enke tells us hedge funds are still in liquidating mode [not blowing bubbles in expansion mode like in the last 4 years 2003-07], this is useful piece of the jigsaw puzzle at least for very short term traders.

With the information herein, we need to decide which is the stronger market force- deleveraging action by hedge funds and others or Warren Buffet's advice to BUY BUY BUY. The score on Friday was in favour of hedge fund selling [and others too] despite Warren Buffet's BUY AMERICAN - the Dow ended down 1% +. The score next week? Who knows but we have to keep analysing.

2008 Oct 19 05:35 AM

[notsosmart:]

i hope the hedge funds deleverage themselves out of business.nobody ever answers my question-what good are hedge funds except to make the wealthy wealthier?they skew the market.

2008 Oct 19 11:16 AM

[Augustus:]

notsosmart,
The wealthy could employ you to make themselves poorer. Or elect Obama.

2008 Oct 19 04:40 PM

[Rakesh Varasia:]

I fully agree with this article since, deleraging process strong hints felt on monday only.... and its effect on all the commodity, stock market has seen.....the process will be on upto some funds sell/bank sell gold as banks ask for fundssssss. i believe process will come on end when gold test US$720-US$690

2008 Oct 23 03:19 AM