Hedge Fund Hell

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 |  Includes: DIA, FXE, FXY, QQQ, SKF, SPY, UUP, XLF
by: Tsachy Mishal

A miserable quarter for hedge funds was capped off with a miserable week. The quarter saw the reversal of several popular hedge fund trades and the worst monthly performance since 2002. In the past week, the market did not move much with the S&P down 0.72%.

However, much of the damage for hedge funds was below the surface. According to Goldman Sachs, hedge funds are overweight the technology sector and net short the financial sector. Last week, the NASDAQ was down close to 2% and the financials rose over 3%, putting further pressure on hedge fund performance. The news of a Lehman (LEH) resolution might help perpetuate the short covering rally in the financials. There is now potential for further redemptions, which is a wild card. I will not try to predict what will happen but will look to take advantage of a disconnect if it does occur.

The economy continued to deteriorate with the 4 week moving average of unemployment claims at 440,250. The credit crunch worsened with credit spreads widening on the week. Growth around the world is slowing and the effects of the stimulus checks are wearing off. We still have not seen the type of fear we saw that marked the bottom of the 2000-2003 Bear Market and valuations are fair at best. I don’t believe this Bear Market is over. However, in the very short term I am somewhat constructive on the market.

The Bear Market rally off the July low is in its seventh week (the rally off the Bear Stearns bottom lasted over 8 weeks). While I believe the rally is nearing its end, I think it can continue for a while longer. At the end of a bear market rally sentiment is usually positive, with people declaring that the bottom is in.

Currently, more advisors in the Investor’s Intelligence survey are bearish than bullish. Anecdotally, I don’t see a lot of bulls other than the usual permabulls. Early this week has positive seasonality and the market is still not overbought. In addition, while Friday’s point decline was large, market breadth was not bad and new lows did not expand. In a bear market the danger is always to the downside and this rally is getting old, so I am cautious. That said, I think the market tries to rally early in the week.

I don’t usually have an opinion on currencies but the US dollar rally has been extreme. Everyone is now expecting a stronger dollar. When there is such an overwhelming consensus the crowd is usually wrong. This week’s Commitment of Traders report shows speculators with their second largest net long position in the US Dollar Index ever, while the smart money is heavily short the dollar. The last time speculators were so heavily long the dollar marked the beginning of a long hard fall for the US dollar.

Disclosure: Author holds a long position in FXE