Hedge Fund Liquidations Bear Some Blame For Market Drop

The recent market action reminds me of the nuclear cow joke:

What do you get when you drop a nuclear bomb on a herd of cows?
Udder destruction.

The financial media has been blaming the market drop on the credit crisis, but I believe the stock market drop is mainly being caused by forced hedge fund liquidations. Some areas affected the most are:

1) Popular hedge fund stocks like Mosaic (MOS), Potash Corp (POT), SandRidge Energy (SD), EnCana (ECA), Apple (AAPL), Research in Motion (RIMM)

2) Closed end funds -- many hedge funds dabble in these. They are not that liquid, so even a moderate amount of forced selling can cause huge price drops.

3) Convertible bonds -- Many hedge funds go long convertible bonds/preferreds and short common stock. But the short sale ban forced them to liquidate many of these convertibles.

Last week I was able to buy some Small Cap Premium & Dividend Income Fund (RCC) at a discount from NAV of over 20%. RCC is basically a Russell 2000 index fund that writes covered calls against their positions. The fund has a termination date of July 2010 when the fund will be liquidated at NAV, so you pick up a nearly guaranteed 10% per year above the Russell 2000 market return.

I prefer just going long RCC. But for the risk averse, you can pair RCC with RWM (inverse Russell 2000 ETF). RCC has a beta of about 0.85, so your RWM position should be smaller than your RCC position.

The good news is that hedge fund liquidations are self-correcting. Once the selling is over, I expect a strong year end rally because of the massive liquidity being pumped into the system by the world's central banks.

Full Disclosure: I am long RCC.

Comments

[michiganjake:]

Totally agree with your thesis. Remember the close of last year? All of the big hitters were up in early January and then the sell off by the hedgies and mutual funds. The drop was enormous. As I recall Apple was over 200 and dropped to 115. After the bottoming out it gradually returned into the 190's before this most recent hit. My take is they make it on the way up, sell to make their returns look good, short to make more money, and then buy back when they get done squeezing! Apple will likely report a stellar quarter again, and is releasing new product info this coming week. They are bullish now and Apple will be up until the blowout quarter is announced. Then the usual Apple COO statement that the next quarter will not be very good, and a sell off for some quick money will happen again. Holiday sales will be strong, the quarter will come in past Apple's stated expectations and the stock will return to high times again. And the beat goes on.

2008 Oct 12 08:26 AM

[Jimmy Lathrop:]

You can never know who originated the title of the article since the SA editors often write them themselves, but I would the take the title one step further and say a wide variety of institutional selling is the direct cause of the market drop.

2008 Oct 12 09:54 AM

[Bob'29:]

Although an excellent article by Mr. Spritzer, he misses an important aspect of the current market crash. Not only have hedge funds needed to liquidate. The Fed underestimated the effect of not bailing out Lehman. In short hind sight this was a huge error. With the collapse of Lehman Brothers the insurers that guaranteed its bonds needed to come up with enormous amount of cash. These insurers held very large equity and commodity positions that they needed to sell at any price to come up with their insurance promises to Lehman bond holders. This is quite possibly many times greater than the hedge fund liquidations. There have been suggestions that the U.S. government buy commodity futures to stabilize the market, as the commodity crash will effect the U.S. agricultural production in the immediate future. Disclosure: Long POT

2008 Oct 12 12:51 PM

[einstein p ...:]

The US government would be wise to protect all of our natural resources, especially coal and fertilizer companies.

The Chinese are going to revamp their farming system and rebuild the infrastructure of their own country. Watch the dry bulk shipping index.
The Chinese have been absent for a while, which has driven prices down along with the forced liquidations of hedge and mutual funds.

Warren Buffet isn't the only one who knows how to buy undervalued assets and, believe me, no one is more patient than the Chinese.

2008 Oct 12 04:31 PM

[jimmy46:]

selling covered calls is a sucker bet

you give up your big winners and keep the losers.

2008 Oct 13 11:23 PM

[MILESCFA:]

"selling covered calls is a sucker bet"

... only if you're a sucker, ie you're selling out-of-the-money calls. This is how you "give up your big winners and keep the losers."

I'm sure this fund is very professionally managed and in today's high volatility environment, option premiums are very high (ie, expensive). Do you want to be a buyer of "pricey" assets or the seller?

So here's the non-sucker strategy: You sell "reasonably" deep-in-the-money calls against the stock owned. The point is, YOU WANT TO HAVE EVERY STOCK CALLED AWAY. This can be a very lucrative strategy because you're collecting the time premium embedded in the option.

Take AAPL for example. Today's close (10/13) was $110.26. If you sold the Nov 08 $90 call at the BID of $25, you're essentially selling for $115 in 38 days. $115/110.26=1.043, or 4.3% OVER 38 DAYS. 1.043^(365/38) = 1.498, or 49.8% annuallized.

I'd take a 49.8% annualized return, would you?

MORE: How did I choose the 90 strike price? It was somewhat arbitrary, in that AAPL "bounced" off support at $90. However, this is a good "rules-based" choice too. Why? You need to be knowledgeable on options, but the 90 strike has a "delta" of around 0.8, or commonly "80". This "means" the option should experience 80% of the upside move of the stock but also only experience 80% of the downside move (note: Delta's change).

Another useful feature of "delta" is that it approximates the likelyhood of the option finishing "in the money", which in our case is what we want. So let's say we always sell covered calls at "80" deltas. If statistics hold, our return would be close to 80% of 49.8%, or 40%, STILL A FANTASTIC ANNUAL RETURN.

And by the way, we don't lose on AAPL until it drops below $85.26 [$90 strike - the time premium we collect, aka ($115-$110.26)]. What is the chance of AAPL dropping from our buy point of $110.26 to our break even of $85.26 in 38 days. Well, this is the same as asking what's the probability of AAPL dropping 22.7% in 38 days? In a sense, it's a trick question. We already know there's an about 80% chance of us breaking even (ok, going to $90, but the point is the same). In this market, it feels like there's a 100% chance of AAPL dropping to $85, but the key point is this - since volatility is high, the option premium is high, so you're being paid for taking this chance, and the pay can be handsome.

Who's the sucker? (Answer: the one NOT making 40% annualized)
**********************...
As for the article, it makes some excellent points. I do think that hedge fund selling has been a big factor, but I also think it feed into the classical fear selling by longs [ the gov "outlawed" shorting, right! :-) ]. And teh arthor did not even mention the $2 dividend historically paid.

The only real question is do you want to be (or have to be) in the market over the next 2 years? We're in a bear market and if it's over, I'd be surprised. Still, it looks like an attractive place to hide and/or play for a bear market rally...

.. whoops. It's been 36 hours since the author bought. Look's like we've already had the rally ;-) .

2008 Oct 14 02:08 AM

[alajac:]

That big rally was on p-poor volume. This baby is going DOWN BIG.

To those who search in vain for 'job growth',
GET WITH THE 21ST CENTURY:
ROBOTS AND COMPUTERS
DO ALL OF THE ACTUAL PRODUCTIVE LABOR.
All that is left is arts, crafts, service,
and sh*t work that isn't profitable to automate
as long as there are $8/hr wage slaves
lined up for miles for every $8/hr job opening.

You can't get bank transparency when the government is guaranteeing the losses. FDIC and every other kind of government guarantee has to go.

Make the banks earn the bailout by giving them the money via equal-dollar distribution to every legal US resident ($700B divided by 350M=$2000 ea.) Then no other stimulus is needed. They'll have to get transparent and extend credit to earn the deposits.

When all governments issue new currency in this manner, there will no longer be an illegal immigration problem.

Write-in Alan Jacquemotte for US President

to show support for this plan,

and your disdain for the other candidates, who, unlike Alan,

didn't see this coming and don't know what to do about it.

2008 Oct 21 03:28 PM