Pretty interesting theory (not mine):
Cheers,
Thomas
Message 18128918
I'd like to suggest a radical possibility about this rally which hasn't, to my knowledge, been suggested before: this rally may not only be different from the other failed rallies over the last three years, but it may be fundamentally different from all previous rallies--ever. By that I mean that all the signals, data points, and metrics which have worked in the past may not work this time.
Believe me, I don't lightly use the words, "This time it's different". But I think it might be.
The foundation of the difference is the proliferation of an entity which was not a factor in previous markets: hedge funds. Five years ago there were roughly 600 hedge funds; now there are over 6,000. The assets under management are up, I think, roughly 20-fold. The compensation structure of the hedge fund managers is fundamentally different from old-fashioned mutual fund structures: instead of relying for their income on a percentage of assets under management, they are paid a whopping percentage of profits (20% to as much as 50% for a firm like SAC). When you handsomely incentivize people for making money--and when there is no concomitant downside for losses, people do the logical thing: they bet big. And the bet that's been consistently paying off in equities for 2 1/2 years has been the short side.
It is no surprise that short interest in equities is at an all-time high.
And, as if the effect of hedge funds were not strong enough, now there's become a lot of retail interest in shorting. Suddenly an investment technique which requires discipline and insight is seen as being a no-brainer way of making money. As an interesting anecdote, I received a cold call from a retail broker last week who was trying to get me as a client--he had no idea of my profession, much less that a significant amount of my work has been tech short-selling. What was his investment idea--the quick-and-easy hook that would get me to sign up with his firm? Shorting Ebay. There's something really wrong when shorting a stock with 25 million shares short is seen as the fast road to riches.
So, in this strange, heavily-shorted, animal-spirits environment a rally has developed. In a normal rally you'd expect a lot of pauses, back-tracing, etc. You'd expect lucky longs who got in at the bottom to take some off the table; you'd expect melancholy longs who got in at higher prices to welcome the opportunity to cut their losses; and you'd expect prospective buyers who missed the rally to jump in when prices recede a little. In other words, you would expect the marginal buyers and sellers to be longs--either putting on or taking off positions. But in this rally many of the marginal players are amateur shorts, who've never seen a short-squeeze, and hedge funds, who like lab rats have been consistently rewarded for pressing the short lever over and over. Every time there's a pause the hedge funds are going to lean against this market. It doesn't matter whether they are right on fundamentals--the people at Long-Term Capital Management were right on fundamentals and had reams of historical data to prove it. But, once a market "senses" that there's a weak hand, it will steamroll those positions. In a normal rally, the faster the rally is, the less its staying power. In a rolling-the-weak-hands rally, ironically the faster it is, the faster it becomes--it's like a feedback mechanism. And the rally attracts new people (some of whom may be nimble hedge funds) who see how easy it is to make money by rolling the shorts.
My view on this has nothing to do with whether I believe equities are undervalued (I don't). My view has to do with the way this particular market may work. I certainly don't know for certain that this particular rally will behave this way. This one may be a fizzle just like the others. And, if it is, it will embolden hedge funds and amateur shorts once again. But, if this one's not the strange one, I think there's a decent chance that sometime in the next couple of years there will be a rally which will utterly confound people--and wipe out 1,000 hedge funds. The hedge funds will be like lab rats who just keep pressing the lever, not realizing that all the lab-workers with food have gone on summer vacation. |
