A Herd of Multi-Billion-Dollar Lemmings

Let’s talk about Friday.

For those of you who were away from your computers, on Friday stocks staged a huge rally with the S&P 500 jumping 2.35%. This move was accompanied by an enormous jump in the US dollar and a dramatic plunge in commodities, particularly oil and gold.

The pundits saw these moves and celebrated the renewal of a bull market in stocks and an end to the commodity bubble. As usual, they missed the picture entirely.

Before getting into Friday’s action, you need to know that the markets today are dominated by an army of hedge funds, quant funds, and other large investors. Collectively these investors manage over $4 trillion in assets. And while they may pursue slightly different investment strategies—hedging, investing multiple asset classes, etc.—overall they tend to exhibit certain basic traits. These are:

• Linear thinking (the dollar rises… so sell commodities; or the euro falls… so buy the dollar).
• Betting heavily by using leverage.
• Going “all in” or “all out” with a position (leading to the occasional emergency liquidation).
• Rapid movement, shifting billions in capital in a matter of seconds.

Combined, these traits can make for very dangerous situations in financial markets. And the impact of these investors is not to be underestimated. Consider the impact two Bear Stearns hedge funds had on the overall market back in July 2007… or the Amaranth hedge fund blow up later that year… or the series of 1+% moves that occurred in the last 25 minutes of trading during the first two weeks of August 2007.

My point is this: Guys like you and me can get whipsawed by these investors’ moves. When a herd of billion-dollar lemmings rush into a particular investment—particularly an investment that was oversold—you will see enormous jumps in a very short period of time.

And that is precisely what happened on Friday.

Do not be fooled, Friday did not mark the rebirth of the dollar or a US bull market in equities. Rather, it was created by large investment groups—all of whom follow similar trading models—rushing into the same ideas.

For starters, you should know that there are several basic investment relationships built into most trading models used by hedge funds and quant funds. These relationships are all inverse in nature… meaning that they illustrate inverse relationships between investment classes. So if one investment rallies, the other plunges.

These relationships are as follows:

• The euro and the dollar are inversely correlated
• The dollar and commodities are inversely correlated.
• Commodities and equities are inversely correlated.

Thus, if the euro rallies, the dollar should plunge. If the dollar rallies then commodities should plunge. And so on.

These relationships are all built into trading models. They’re also some of the most basic rules of analysis employed by traders and analysts on Wall Street. As I mentioned before, these guys are linear thinkers. They follow an “if A, then B” method of trading. So if one of the above relationships is triggered, they all pile in.

My suggestion for today is to watch what happens in the gold markets closely. We have been given a fantastic opportunity by Friday’s madness. If gold remains depressed or plunges further today, I’m adding to my position.

Comments

[keanemd:]

Hey

I feel the same way. The real big boys are just getting back to work and I'm sure will see the joke that is this month's trading going on. Gold will be up 5-10 percent in the next six months based on the fundamentals of global insecurity, gold not being available, the rest of the world raising rates, and the fed dumping more dollars in a second stimulus to keep the consumer spending.

2008 Aug 11 01:51 PM

[Roowns:]

You miss one point here. Those relations are driven by investors moves and fundamentals of the global economy. If one sells commodities then needs to invest those money in something, like stocks, putting pressure to the price of that asset.
No institution you mention above have most of it's portfolio on cash, so yeah. If it's SELLing something must be BUYing something.
There's no such linear thinking. This doesn't mean that after they move to stocks and those become somehow overbought because of the crowed followers they won't run with the profit and move to something else again.
I don't understand why you have to judge some institutions that all this time made real money from commodities while you were watching your stocks dropping. You should learn and not judge, and take advantage of all those moves.
Market is far from being perfect and responding perfectly to change in economy.
And I think it might be too early for what you imply. Once started, the commodity drop might be significant since the advance in price was huge and people will take profit at very lower levels.
I expect at least 2 weeks of oil drop, and gold might follow.

2008 Aug 11 02:04 PM

[CLH:]

Dont make fun of those who are making big money while you lose.
Maybe they are right.

2008 Aug 11 02:22 PM

[whidbey:]

Good observations. Most of the profound algorithms are based on relationships established more or less by regression studies of various strips. I use neural nets, but there are alternatives. The pay-off is the results which require much sifting and sorting to see what is really happening, as compared to what one expected. Finally relations did not last forever, but the coefficients usually let you know when things are shifting. By and large the so-call quant is a boon to all since he thinks instead of wandering around in caves with a torch.

2008 Aug 11 03:00 PM

[GMiki1:]

I agree with you, Graham. Follow the fundamentals. Unfortunately, a lot of people try to follow these funds and trade in and out after them. I think it's a crazy trading strategy. Gold will recover--if not in six months, then, whenever the next wave of horrible news hits. At that point gold will recover royally. Because of the fundamentals.

2008 Aug 11 04:53 PM

[mkreisel:]

Too many are doing the short dollar, long commodities & foreign currencies carry trade. Now it's payback time.

2008 Aug 11 07:24 PM

[pitaking:]

The only way to play gold right now is on the short side. DZZ has been a great trade over the last week and as the GLD sees liquidation from every mom and pop investor who where told that gold was a great hedge against the dollar and inflation during the 1st half of the year, the drop will continue. With the S&P holding above 1292 today, the money is going to continue out of commodities and EM, led by gold and into small cap and tech. GLD doesn't see support until $77.50, still lots of room on the downside.
Long DZZ and EEV

2008 Aug 11 08:44 PM

[Pj568:]

Minor correction needed.

Author says Bear Sterns Hedge funds blew up in July 07 followed later that year by Amaranth. Amarath's demise actually occurred nearly a year earlier in September 06.

2008 Aug 12 12:47 AM

[Tony Daltorio:]

Your comments are spot on. Right now I am telling my clients to begin accumulating commodities and commodity-related equities, along with other currencies. And also to begin shorting the US stock market and US dollar. The crowd is always wrong!

2008 Aug 12 02:08 PM