2007_08_31 — “August’s subprime mortgage contagion led to a widespread liquidation of…”
August 31, 2007
August’s subprime mortgage contagion led to a widespread liquidation of…
August’s subprime mortgage contagion led to a widespread liquidation of equities, commodities and low-grade credits. The sell off was exacerbated by the largest jump in overnight loan rates in six years. Correspondingly, inflation in China accelerated to the highest level in a decade, volatility soared, and U.S. consumer confidence reached a two year low. The market environment negatively shocked the performance of most hedge fund sectors, with the CS/Tremont Hedge Fund Index down -1.53% and some notable individual funds down over -20%. The Managed Futures sector was particularly affected, down -4.6% as an overall flight to quality by investors triggered reversals in most of the sector’s established energy, fixed income, and currency trends.
Speculation is that a sizeable multistrategy fund or proprietary desk was the catalyst to the market madness by suddenly dumping its positions in early August. That triggered a wave of selling and deleveraging that in turn caused stocks to move in unexpected directions. Cheap value stocks got battered and expensive and popularly shorted stocks rose. Specifically, in order to reduce risk, managers simultaneously liquidated their long and short positions. In order to do that they had to, A) Sell the good cheap stocks that they had liked, thus driving their prices even lower; and B) Buy back the bad expensive stocks that they had shorted, thus driving their prices even higher. This paradoxical movement caused a lot of pain on Wall Street, especially among quantitative hedge funds.
The parameters of polite conversation have shifted and recession is the word on everyone’s lips. Even with the Fed’s half point rate cut, the chill in the debt markets is likely to linger through the end of the year. None-the-less, even with the uncertainty, there is hope. We are not yet boxed in by recession and the corporate sector is stable. Although most housing contractions have coincided with economic contractions, or at least major GDP declines, the blow up in the residential sector has not yet leaked into commercial and non-public construction. Corporate fundamentals and hiring demands remain robust, and overall, the corporate sector neither over leveraged nor over invested in the past decade. On top of the Fed’s solid dose of easing, the market is discounting 2 more rate cuts of a quarter percent by April 2008. Thus, the Fed is reducing the odds of a very bearish downturn.
Following recent market jitters, the retail investor will probably avoid real estate, housing related investments and high yield debt. In addition, low government bond yields may not elicit interest. Therefore, aside from cash and bank deposits, investors are left with the choice of investing in international equities and emerging markets, which did not get hit hard in the latest round of volatility and have solid value and growth prospects. In addition, energy stocks and commodities are not expensive and remain good candidates for riding the coattails of global growth.
Michael Ashley Schulman, CFA
Originally published at https://www.hollencrest.com.