Looking Back at 2004 and the Impact of Hedge Funds on the Market

Last year the S&P 500 returned 8.99% while the DOW rose 3.14% and the Nasdaq managed to close the year out at 8.58%. According to the CSFB Tremont hedge fund index the average hedge fund return was 9.64% last year. "Hedge fund managers attribute their lower performance in 2004 to low volatility and low interest rates. Some have also had a difficult time since the start of 2005 because they have been shorting the dollar in expectation of further falls, when the dollar has recently strengthened," says Reuters.

The CSFB index shows that most hedge funds produced strong returns in the first and fourth quarters, but had nasty slumps in the middle two quarters. I can recall statistics showing that many hedge funds were in the red in July.

Although looking back right now last year seems to have been dominated by the war in Iraq, the Presidential election, and a large fourth quarter rally in the markets, for most of the year the stock markets were drifting sideways in a very narrow range. The need for positive returns without much opportunity for it caused many hedge fund managers to try to participate in opportunities that were not there.

In the summer they got whipsawed and then in the fourth quarter most of them jumped into momentum technology stocks. Much of the rally in the fourth quarter was likely due to hedge funds jumping into these stocks and creating a self-fulfilling prophecy out of the 4-year Presidential market cycle. Whatever the case, we've now seen huge profit taking since the fourth quarter 2004 came to an end.

There are now approximately 8,000 hedge funds. Hedge funds are the fastest growing segment of the financial industry and are attracting hot money the same way IPO's did during the late 1990's. Corporate raider Carl Ichan, seeing their new potential, recently launched a hedge fund of his own with $1.3 billion in investor money.

The growth of hedge funds and shrinking volatility in the market has created important changes in the way the stock market has been acting. I touched on this a little bit in some of my writings last year. Hedge funds are now making up 82% of the trading volume in distressed debt securities and 30% of the volume in low-grade bonds and credit derivatives.

Friend and hedge fund manager Ike Iosiff employs short sales and options to carry out conservative options strategies as one tool for his fund. He says:

"Imagine the impact on the financial markets from thousands of hedge funds employing similar approaches on a much larger scale in order to accommodate multi-million dollar portfolios."

"First of all, raw put/call ratios are irrelevant. A large number of puts/calls are bought/sold not because of conviction with regard to the directional move of a stock/index, but because of the very lack of it!"

"Second, when everything is already pre-sold or pre-bought, there is very little urgency to sell/buy, which reduces volatility, and volatility premiums."

"Third, the existence of this type of hedging strategies results in plenty of "uncompleted" break-outs or breakdowns. As soon as a stock/index appears to break-out or break-down, the hedge strategy kicks in, and the "break" gets negated. This has been much more prevalent in the indices, where funds can make multi-million dollar bets due to the available liquidity."

"In an environment like this, the chances for success are precious few for individual investors who do not know how or can't play the same game. In my view, those few chances for success -for individual investors- can be found in ETFs/stocks that have little following by hedge funds."

Hedge funds are making indicators such as the put/call ratio and the VIX - volatility index - more difficult to use when trying to gauge market sentiment. However, when you have a lot of people in the stock market all doing the same thing it usually becomes more difficult for everyone to make money.

Individual stocks are also being affected. For the past few years, I have been following gold stocks very closely. I've seen them go through several corrections. Each time a bottom is made there is usually massive selling volume in Newmont mining, while many of the smaller junior mining companies I follow won't see same amount of selling volume. What is happening is that these stocks - even if they have market caps of $500 million or $1 billion - are too small for the larger hedge fund players to buy.

These hedge funds try to play the gold stock momentum by buying Newmont and always seem to sell out at the same time when the momentum fades, thereby creating these high volume selling spikes. Newmont is also one of the few gold stocks with a high degree of option activity, which gives these hedge fund players an additional reason to play it.

Opportunities in the Next 6 Months

I think we will see two main opportunities in the financial markets over the next two quarters:

1) A continuation of the gold bull market.

Gold and gold stocks began corrections in the fourth quarter of 2004, which have carried over into January, 2005. At the same time the dollar has rallied, squeezing out hedge funds that went short the dollar. Once the current dollar rally comes to an end, I expect fundamentals to take over and the dollar to resume its bear market. Gold should subsequently test its high and break out, bringing another big run for gold stocks like we saw in 2003.

2) A buyable rally in the broad US stock market

So far this year, the market averages have been underwater and have been breaking technical support levels. I expect this pullback to continue at least into February and once it ends we should see a quick and powerful bounce in the S&P 500, Nasdaq, and DOW fueled by short-covering and investor excitement.

Last year we saw the market sell-off sharply during each earnings season and then rally once those sell-offs came to an end. These rallies began in March, May, and August.

Once this correction comes to an end we plan on putting a portion of my portfolio into sectors and stocks that have held up well during the decline. I want to buy stocks that have stopped dropping and have already created support levels near the next bottom. This way I will have a well-defined entry point and risk level when we take these positions.

I am going to use internal indicators for the markets instead of just the put/call ratio, VIX, and other sentiment indicators to try to gauge when the market is near a bottom. Last year the ratio of down to up volume on the NYSE hit 8:1 levels on each of the three major bottoms last year while the ratio of falling to rising stocks also hit 8:1. This was a signal that a panic-selling washout took place. I expect something similar to happen when this current correction nears its end. The next support level on the Nasdaq is 1,975. It could happen there.

If I do buy a basket of strong stocks I will sell them once the market rallies and the indices get overbought according to momentum indicators such as the stochastics and macd. At that point I will have to evaluate the strength of the rally to determine what kind of trend I believe the market is going to be in going forward. I don't have the confidence in the stock market to use a buying opportunity to try and buy and hold for the rest of the year. At best the market will likely remain stuck in a trading range.

Gold Will be The Trade of the Year

I think the trade of the year will be in gold, however I want to buy into gold stocks safely.

Going into this year, I had planned on buying into gold stocks with two main buying points - first a selling panic in the gold stocks like we saw last May and secondly when the relative strength of the XAU gold stock index turned up against gold. I took this as my buy signal last August.

It may be that gold stocks are not going to make another panic bottom. Although I do think there is more downside to gold, the stocks themselves may have put in their ultimate bottom. I will need to watch the action in the gold market for another 1-2 weeks to come to this conclusion. If I do, I expect the XAU will simply go sideways through the end of the quarter while gold continues to trade weak.

However, if this happens, some of the stronger gold stocks - may break away from the XAU and start to rally. If that happens - instead of a panic bottom - I plan on buying these select gold stocks as they break away and then buying the bulk of my gold stock position when the relative strength of the XAU turns up against gold like it did in August.

2005 - A Shaky Start for the Markets

I feel a little uneasy about the huge growth in hedge funds over the past few years. The late 1990's bull market was driven by huge injections of liquidity into the financial system. This gave rise to the Internet bull market and the post March 2000 bear market bust and recession. In many ways, the speculative excesses of the 1990's in the stock market and the economy have not been worked off. Instead liquidity has floated through one sector of the financial system into another - whether it be in real estate, the bond market, even record levels of volume on the penny stock OTCBB exchange in 2003, rising commodity prices, and now in hedge funds. The S&P 500 currently trades at 21 times earnings and gives investors a microscopic dividend yield of 1.8%.

Much was made a year ago about the four-year election cycle. Many experts and analysts made note of the fact that the market historically rallies during a Presidential year. What is also true is that post-election rallies tend to fade between the middle of December and January with large declines the following year. In fact, the year of a Presidential election has usually been the most bullish year in the markets and the year after the most bearish.

I believe that last year's fourth quarterly rally was fueled by hedge funds that made a self-fulfilling prophecy out of the four-year Presidential cycle election. They bought and bought, pyramiding the market high. As soon as the calendar year changed and their 2004 books were closed they sold, creating massive volume on the Nasdaq and the NYSE, all to the downside.

If this is indeed what has happened, then such a rally has been driven by liquidity, speculation, and the current structure of the financial markets themselves - dominated by hedge funds and program trading - and not by real fundamentals. Even the Federal Reserve has seen signs that this may be the case. According to the minutes of the Fed's December FOMC meeting:

"Some participants believed that the prolonged period of (monetary) policy accommodation had generated a significant degree of liquidity that might be contributing to signs of excessive risk taking in financial markets evidenced by quite narrow credit spreads, a pick-up in initial public offerings, an upturn in mergers and acquisitions activity, and anecdotal reports that speculative demands were becoming apparent in the markets for family homes and condominiums."

In March of last year short-term interest rates in the US, Germany, and Japan averaged only 1%, their lowest level in more than 100 years.

According to a reporter for the Australian newspaper,

"This concern has been reinforced in recent speeches by members of the Fed's Open Market Committee, most importantly by the president of the New York Fed, Timothy Geithner, last week. The New York Fed runs market operations for the Fed in Washington."

"Geithner acknowledges that many aspects of the economic landscape, such as growth, look reasonably good, but he also thinks financial markets are not pricing in enough risk."

"He says that the dramatic reduction in risk premiums implies markets think future macro-economic shocks will be more moderate than in the past and more likely to be absorbed without broader damage to economies or the financial system."

"It also suggests an increase in confidence that central banks in the US and elsewhere can keep inflation stable at moderate levels, and diminished uncertainty about what the Fed will do with interest rates. And low credit spreads imply the serious imbalances in the global economy will be diffused smoothly."

"For all this to be true will require improbably good global economic management and an awful lot of luck."

"What could upset the apple cart? Many things, but two stand out."

"The Fed may raise rates this year by more than markets expect, triggering a reaction in the US bond market, where long rates have been remarkably low. If the 10-year bond rate begins to rise, it will send shock waves through the US economy and financial markets because it is the base for a lot of household and corporate financing. This would put pressure on credit spreads in corporate and other debt to widen."

"The other factor that would change the outlook would be any change in the willingness of Japan, China and other Asian central banks to continue buying US Treasury paper. That would hit both the US dollar and US interest rates."

"Still, those who bet on a rise in US bond rates last year lost money, and the same could happen again. But there is a dangerous amount of optimism priced into credit spreads."

Going into 2005, we are in a situation where low long-term interest rates are showing a sign of high confidence by investors in Alan Greenspan and the Federal Reserve, despite an annual inflation rate of 3.3% for 2004, while hedge funds and program trading has turned the financial markets into something of a casino.

There are some things in the market, which simply do not make logical sense to me. For instance, despite the fact that the Federal Reserve has been raising short-term interest rates and has announced that they will continue to do so this year, the yields on the 20-year treasury bonds have been steadily dropping since this summer.

Perhaps in a year we will be able to look back and see what the bond market is currently forecasting. I do know that I want to maintain a high degree of flexibility and stick with my own investment philosophies. These are to invest in sectors that are outperforming the rest of the stock market and have strong fundamentals and to be patient enough to wait for those opportunities when it is necessary - opportunities that most hedge funds and institutional players are not trying to take advantage of.

I am looking forward to 2005, and believe that we will soon have a great opportunity to buy and hold gold stocks. If you've been following along closely with us you'll know how excited we are about this opportunity to invest in the gold bull market. It's the kind of set-up that comes along maybe once every decade and we are here, prepared to take full advantage of it

To find out what gold stocks Mike Swanson holds and plans on buying subscribe to his free Weekly Gold Report at http://wallstreetwindow.com/weeklygold.htm