Market Observations On A Difficult Day

by: Jeff Miller

This is the sort of day that scares the daylights out of most investors. If they read news or tuned into CNBC, it was even worse.

The News versus Real Information

Much of the bearish commentary involves long causal chains of events -- one domino after another. It sounds erudite. It seems persuasive, since dominoes were falling today.

What is lacking in most analyses is an effort at quantification. Frequently, those who try to provide such information are shouted down. Ultimately, the refinancing of mortgages, the unwinding of hedge fund positions, the response of homeowners and government agencies, and the actions of corporations are all marginal actions. It is not like a light switch.

There is a stereotype in the market that everyone who took a sub-prime loan cannot pay. That all Alt-A borrowers are liars. That none of the teaser-rate borrowers have acted to refinance during the last few years.

What is needed is some sense of magnitude, and the numbers are so easily misconstrued. A mortgage executive was interviewed on CNBC last week and admitted that defaults were up 100%! They had 30,000+ mortgages and defaults and gone from 25 t0 50, well within their loss reserves.

Most of the stories about "subslime" spreading to prime mortgages are completely lacking in quantification--the aggregate impact. Added to this is the assumption that these borrowers are not qualified to refinance.

The problems are obvious, but the effects are difficult to predict. When the market lacks information, sellers act on each piece of information and potential buyers back off.

The Hedge Fund Effect

Some of the best commentary today came from James Altucher, who manages a fund of funds and sees hundreds of hedge fund pitches. He explained on RealMoney, TheStreet.com's paid site, that many hedge funds borrowed at 5.5% and bought mortgage obligations yielding 6.5%. To get the "holy grail" of hedge fund performance, they leveraged this 12-1 or so and seemed to show consistent strong yields with little volatility. We know this to be true, since this is the environment in which hedge funds like ours have been competing for assets. The leverage method looked good until the fund's longs went down and the shorts went up. With 12-1 leverage, it takes little to blow out the entire fund.

It was the quest for yield....

On CNBC's "On the Money" Altucher cited another strategy -- put selling. This strategy has worked for years -- until today. These funds are also blowing out.

Implications for the Average Investor

For the average investor, it means that quality stocks are on sale. The hedge funds must sell to cover marginal calls and redemptions. Many observers noted that today's trading had plenty of selling in good stocks and buying in (widely shorted) marginal stocks. To the savvy observers this looked like hedge fund liquidation.

The Time Frame

The process did not necessarily end today. The psychology of Fridays has now changed. A few weeks ago, everyone was worried that big mergers would be announced on the weekend. No one wanted to be caught short. Now everyone fears that more bank and hedge fund news will come out. How much anticipation was built into today's trading? Who knows?

At "A Dash," we are less concerned about follow-on economic effects, although the economically sensitive stocks got hit today. Everyone's forecasts build in some effect on GDP from the housing situation. The extreme views forecast recession, while others see a haircut of 0.5% or so. It was interesting that even Nouriel Roubini, interviewed by Maria Bartiromo tonight on CNBC, was looking only for a slowdown in growth, not a recession.

Conclusion

Those with bullets to fire are getting a chance, but most are waiting for evidence of a bottom. This is notoriously difficult to predict

We have some modeling on this process -- more later.