By Dan Knight

The month of August is quickly becoming a month of misery for hedge funds and short sellers in particular. Like last year, when the credit crisis seemed to initially explode and cause many large hedge funds, particularly quant-based ones that employ long/short strategies, to suffer massive losses, this year's August is doing the same.

I received an email from United Airlines (UAUA) today, "An open letter to all airline customers" was the subject line. In it, they bemoan the fact that speculators are a larger percentage of traded contracts than years before and that they believe the speculators are responsible for driving up the price of oil, and thus their fuel costs. Look in your junk email box and you probably received it as well.

There has been a lot of debate over this recently, but as outlined in the WSJ a couple days ago, commodities speculators aren't dealing in the underlying, just the cash settlement difference of the futures contracts. Unless there has been significant hoarding or some other tangible change in the supply or demand for the commodity, speculators, and hedgers for that matter, don't materially affect the underlying price. If prices are getting too disconnected from fundamentals, then other speculators will come in and short contracts, driving the price to equilibrium.

There was an interesting article in the Wall Street Journal; click this link, wsj. It stated that Momentum strategies, buying stocks that have been up recently, have been trouncing Value strategies, buying those  which are relatively cheap.

The magnitude was staggering, +71% for "Mo" vs -54% for Value, and it compared this environment to the tech bubble in regards to commodities. Additionally, there was an 18 year chart showing the annualized performance difference between Momentum and Value, with a big spike up favoring Mo during the tech bubble, and a subsequent plumment, favoring Value during the bubble pop.

Price momentum is a well known "market anomaly",defying efficient market theorists. In general, the effect is stocks that have been outperforming in the past tend to continue to do so, and vice versa. Whether there is some information leakage that allows the better informed to bid up stocks over time, or just a variant on the "greater fool theory", buy high in hopes to sell higher, price momentum [PM] is an empirically justified market phenomenon (at least without trading costs!).

Yet, PM doesn't work the same in all markets and all months. I ran a simple analysis using trailing 6 month performance PM measure, ranking the largest 1500 stocks monthly over the last 25 years into deciles, with the best performers ranked 1, worst 10.

I noodled around with the recent monthly history of regular gas prices since 2000 and monthly performance of the Energy ETF XLE. As you can imagine, the two time series are correlated; as gas prices rise, so does the XLE. What was curious though was the recent large divergence between the increasing price of gas and the zooming performance of the Energy ETF.

The link to a spreadsheet with the data and a chart shows the story. Gas vs XLE, shows that over the last 24 months, from June 2006 to May 2008, gas prices have gone from $2.78 per gallon to $3.50 (the $4 stuff hit this month) - that's a 26% increase. But the XLE over that time has risen 60%. The prior 6 years show that gas and XLE trended in a narrow band together, so only recently has the relationship widened.

Over the last year, the average SP500 stock is down about 14%, with the peak back in October. Historically during down markets, "growth" stocks tend to underperform "value", perhaps due to their greater market sensitivity (beta) or that value stocks are relatively cheaper in the first place. Since 1970, the performance of large cap value has been about the same as large cap growth during positive markets, but value falls less than half as much as growth during market declines.

This relationship has been reversed over the last 12 months (and longer) during the credit-crunch-inflation-spiking-confidence-declining market. Indeed, the Vanguard Value Index is down 10.3% over the last year whereas the Vanguard Growth Index off only 2.75%. So yes, Growth is doing better than Value, but unusually so in a bear market.

When constructing a long/short, market neutral portfolio, the goal is to have the short portfolio "perfectly" hedge the long portfolio, neutralizing the market's influences, leaving the relative performance between the two from just stock selection. This construction is easier said than done.

A common technique is to construct a well-diversified long portfolio, then use a "mirror image" short portfolio that has similar industry, sector and other exposures to match the long portfolio?s market sensitivities. This could be a "dollar-neutral" construction, or the same amount invested long and short, but this might not form a perfect hedge. Despite similar sector and industry exposures, parallel long and short portfolios can have quite different market sensitivities.

Despite the economic slowdown, or perhaps due to the pressures on beer drinkers from the slowdown, Molson Coors (TAP) reported better than expected sales and earnings for the recent quarter and the stock foamed up over 8%. TAP has been a position of mine for several months, up over 25% before the pop. The stock has appeared cheap relative to earnings and sales, had a nice pattern of improving earnings estimates from Wall Street and few short sellers willing to bet against it - and the news proved they were right to be cautious.

Before the Coors - Molson merger, Coors stock ticker was "ACCOB", or Adolph Coors Company Class B, but traders used to quip it was "A Cold Can Of Beer". "TAP" is the new moniker and apparently the merger is working well; the initial clash of the Coors and Molson cultures are integrating nicely. I will continue to hold the stock, hoping for sustained growth and good performance as more investors come around to the streaking Silver Bullet.

Part of the story is that people forget that the mathematical definition of beta is a combination of the stock's correlation with the market and it's co-variance, or co-variability, with the market. Thus volatile stocks with little market correlation (think health stocks for example) can appear to have modest betas versus stocks that are perfectly correlated and have lower volatility.

United Natural Foods (UNFI) reported less than expected earnings last week, and that negative earnings surprise drove the stock down 25%. Since short the stock, I am elated, and one of the several reasons I am short is that the stock had missed earnings expectations the last couple quarters and analysts had been revising downward their future estimates.

This month seems to be one of those particulary inverted months, with past winners lagging past losers by over 5% mtd. An article in Hedge Fund Daily confirms that other quants are experiencing these results . My guess is that investors are jumping into the stocks most beaten down from tax loss selling or window dressing, and driving their prices up, while stocks that had been doing relatively better are being neglected, or worse, sold off.

One question I get asked a lot on running my long/short strategy is what is the return of my longs versus the return on the shorts, and do I earn a bigger "alpha" on one or the other. Generally the short side earns bigger excess returns, as the thinking goes that since fewer investors short, there is more inefficiency "on the short side", since for most investors the only way to express a negative view on a stock is to either not own it or underweight it relative to a benchmark.

I ran the numbers on my portfolio over the last 6+ months since July. The estimated return on my longs over the period was -12.31%, which though a loss, compares favorably to the -13.62 loss of the S&P 500 during that time, for a slight excess return of roughly 1.3%. My portfolio selects from roughly the top 1500 US stocks, so for an even more appropriate performance comparison, the S&P Composite 1500 was down 14.14% during that time, giving me a 1.8% excess to that benchmark.

In this panic driven market environment, I did some research to what might happen after the plunge. I looked at big monthly market declines and how Value stocks, as defined as the lowest 20% of stocks ranked by Price to Book Value did relative to Growth stocks, the highest ranked 20% by P/B, and the market in general.

My "down and dirty" analysis was this - look at all months that the market fell by at least 5%, such as now. Then look at how the Value and Growth stocks performed over the next 6 months. Since 1974, there have been 28 months where the market fell by at least 5%. The market grew by an average of 7.9% the following 6 months after the decline. However, Value stocks averaged an 11% rise, a statistically significant excess return over the market. Growth rose about 7.4%, more or less inline with the general market.

Theragenics Corp (TGX), a medical device company serving the cancer treatment and surgical markets, popped in the last half hour of trading yesterday, rising over 5% with no headlines from various news sources.

The chart below shows the price behavior. Could this be the start of something big? Possibly short sellers quickly covering in front of news? Or just a market micro-structure event - big eager buyer, no market sellers, weak specialist that faded the stock to the buyer in expectation that it will come back in after the buyer is done?

After the close Thursday, Steak n Shake (SNS) announced unfavorable and less than expected earnings and warned that 2008 guidance "should no longer be relied upon". The stock fell 15% Friday.

Awhile back I swapped a successful short in PF Chang China Bistro (PFCB) for SNS, and with Friday's plunge, I am firmly in the black with this short as well.

Hedge funds tend to report better than average returns in December. This isn't the greatest surprise, since they can earn massive incentive fees (typically 20% of gross profits) based on their year-end performance. As discussed in their paper "Why is Santa so kind to hedge funds? - the December return puzzle", authors Vikas Agarwal, Naveen Daniel and Narayan Naik found that this spike in December returns tends to come mainly from those managers that have the ability to inflate their returns, through favorable marking of positions, or aggressive year end trading, among many other interesting findings and interpretations.

I did some research to replicate the authors findings and sure enough, I found that by looking at index data from Hedge Fund Research [HFR], I found that December returns were by far better than average monthly returns, about 1.2% better in aggregate. From 1990-2006, the average December return for the HFR Fund of Funds Composite Index, a good benchmark for hedge funds in general, and less susceptible to survivorship and self-reporting biases that plague most hedge fund indices, was 1.94%, while the average monthly return of the previous 11 months was 0.72%. Amazingly consistent and strong year end finish for an industry! This excess was statistically significant and not driven by market conditions, but apparently to more nefarious explanations.