Additional References
EWFF, September 2005
Hedge Fund Considerations
Suddenly, all the growth in the hedge fund industry is concentrated in one of two camps of investors. One camp is “growing impatient” with slight returns and “starting to demand that managers take on a little more risk to boost returns.” A story headlined “Make My Investment Riskier, Please” describes this group as “investors who think that under all circumstances, higher risk equals higher return.” The other camp is even more antsy – it wants its money back. After $400 million turned up missing at a Connecticut-based hedge fund, the August 29 issue of The Wall Street Journal labeled the situation, “hedge fund Havoc.” “What we’re now seeing is an increase in what could be called hedge fund fraud,” says a lawyer in the New York Times version of the same story.
The discovery of illicit activities in the hedge fund industry marks its advance to the same breaking point that hit the accounting and Internet industries in mid-2000. At that time, EWFF cited the emergence of the first wave of market scandals as confirmation that the bear market was underway. As we explained at the time, scandals break in the wake of a mania as participants snap out of their compliant trances, look critically at their holdings for the first time and begin channeling the negative emotions of a falling social mood toward the entities in which they were formerly so enthralled. After the collapse of the Internet stocks, everyone wondered how “people who should have known better bought into the lie.” The same wonder is being expressed today as big money investors with exclusive access to hedge funds (at least until very recently) bought into even bigger lies.
It’s now time for hedge funds to move to the top of the scandal sheets because they are a primary driver behind the push to a final new high in a host of different markets and indexes. There’s no way to push social mood higher, but, as some of the latest issues of EWFF, EWT and the Short Term Update have pointed out, well-organized pockets of investment capital, like the investment syndicates of 1929 and the hedge funds of the late 1990s and 2000s, appear to be able to facilitate the formation of multiple extremes at the end of bull markets of Supercycle degree and higher. Some of the reasons noted so far are the extraordinary leverage employed, targeting of specific issues and sectors, and hedge fund managers’ extraordinary inclination to herd. Another factor is their ability, due to an almost complete lack of oversight within the industry, to flat-out lie. According to the suicide note of a principal in the latest hedge fund blow-up, his firm’s fraud dates back to 1998, when the long-term topping process started. The managers of the fund probably didn’t expect to lose money. But once they did, they took full advantage of lax regulations and stayed in business by simply claiming a profit and paying those who wanted out with the money they got from those who wanted in. Thanks to the GSC peak and its aftermath, money continued to flood in through the first part of 2005. Being in the hands of professionals rather than rank amateurs, it found its way to relatively depressed areas such as commodities, real estate and small-cap stocks. Wisps of the old fervor were revived, but an overall waning effect is visible in a dramatically reduced speculative frenzy. The reason is that wave 3 down is beginning.
The Elliott Wave Theorist, September 2005
EWT in 1983 predicted a mania for stocks (see Appendix of Elliott Wave Principle), and we have been well aware of its spread to other markets ever since EWT first coined the term, “The Great Asset Mania,” back in 1996. The Elliott Wave Financial Forecast postulates that the hedge funds are a major mechanism through which investors have extended so many trends. People have created and supported the hedge fund industry to express an extremely optimistic social mood. Why is this particular mechanism special? Because (1) hedge fund managers are paid primarily on profits and (2) they play with other people’s money. If a seasoned investor were buying only for his own account, he would never pay 1240 for the S&P, 680 for the Russell 2000, $450 for an ounce of gold, $65 a barrel for oil or $3m for a house with no money down. But novices don’t know better, and managers of other people’s money don’t care. The only way that the Russell 2000 index could have climbed to new all-time highs while the Dow, S&P and NASDAQ have lagged so substantially is that hedge funds have been targeting that index because other hedge funds are targeting it. It’s herding at its most primitive level; there is little rationalized analysis of companies, just the bulling of an index. 
Figure 1 from Dr. John Hussman reveals this stark preference, which is based entirely upon which index the stocks are in! Commodity markets are in the same situation. Oil and copper have made new highs while agricultural commodities languish at low prices. Nevertheless, every mania ultimately ends. There is no free lunch, no endless trend.
The EWFF Short-Term Update, August 19, 2005
For a look at the all-the-same-markets chart click here. It's certainly taking its time, but, one by one the big turn is sinking its hooks in. The stack runs in chronological order from the first to peak, which was silver, through to the last, which is likely to be the CRB. With a potential peak now in place for oil, commodities may be turning now, too. But new highs are certainly feasible as the economy and all its dependent variables will tend to trail as they did in late 2000 and 2001. If it follows its usual pattern, the S&P hedge fund Index will be right behind the S&P.
The hedge funds index's tight shadowing of the S&P shows very clearly that these funds are manifestations of the upward surge in social mood. They came in together; and now that the public is being ushered in through lowered minimum investments of as little as $25,000 and state and city retirement systems are piling in (in much the same manner that they increased their equity exposure in late 1990s), they will go out together. One of the ironies surrounding the recent rush to "hedge" funds is that many of are getting on board because they believe these instruments offer some protection from falling stock prices. But our all-the-same-market chart shows their tight correlation to the great reflation levitation that has guided markets since October 2002. Apparently, advances of Supercycle degree, like the current peak and that of 1929, produce super-organized investment groups that are extremely efficient miners of the social euphoria. Hedge funds certainly herd like average investors. In fact, recent articles about the cliqueish behavior of hedge fund managers illustrate that they may be even more imitative. They all follow the same strategies, work in the same places and give to the same charities. There's virtually no office space in Greenwich, Connecticut, for example, because hedge funds are now lining up to move there. A few weeks ago there was that story in The Wall Street Journal about the trouble managers of new funds are having finding names. "It's nearly impossible to find a name that isn't taken," said the manager of a yet-to-be-named fund. But who says you have to name your fund after a Greek god, mountain range or solar system? A truly innovative manager with a distinct approach to making money should have no problem coming up with a moniker that implies stellar investment performance.
EWFF, August 2005
Hedge Fund Considerations
In 1927-1929, banks formed affiliates for the purpose of exploiting intensively the diverse opportunities for profit associated with successful stock operations. The additional gains which accrued from guiding the price upward dulled the bankers’ realization of the danger in such tactics. Though the operation was obscured by the complexity of the process, the bank was actually engaged in stock rigging. It was easier to advance further sums to assure the success of the venture, than to write off an initial loss. Before the bank officials realized the situation, they were so heavily committed that retreat was impossible.
This quote is from the chapter on “Pool Operations” in Ten Years on Wall Street, which came out in 1932, three years after a Supercycle degree peak capped a 75-year stock market advance. Five years after a Grand Supercycle peak, which completes a rise of more than 200 years, similar coteries of big money, brains and Wall Street experience are at work in the marketplace. In a fascinating reflection of the higher degree of this peak, however, the size, complexity and range of hedge fund investments is much broader and more complex than those of the pools and syndicates in 1929. Another key difference is that hedge funds didn’t peak with the major averages in 2000; they have continued to expand through the first rebound in the bear market.
Due to hedge funds’ secrecy about their operations, the exact extent of their “affiliation” with the banking industry is unknown, but it is almost surely commensurate to that of pools in 1929. According to The Banker, a banking industry journal, banks have increased their exposure to hedge funds through prime brokerage services, which includes credit in the form of direct loans and stock, sales and trading on behalf of hedge funds and myriad forms of “proprietary trading” in which they trade directly with hedge funds. Many have also become entwined through direct investment or money management relationships. According to a recent Wall Street Journal exposé on Goldman Sachs and its burgeoning hedge fund/trading business, the firm “got more than a third of its stock revenue last year from doing business with hedge funds.” Proprietary trading, which is sometimes used as a code word for banks’ internal hedge fund operations, now accounts for two and three times the total generated by investment banking. After an extensive study through the early part of 2005, Charles Prescott, managing director of Fitch Ratings, concludes that problems at hedge funds “could lead to the development of systemic risk.”
Monday’s Wall Street Journal reveals that there are now no less than 8000 hedge funds in existence. “It’s impossible to find a name that isn’t taken,” says the operator of an as-yet unnamed start-up fund. In 1929, Ten Years on Wall Street notes that in “the later stages of the bull market” one of the last things to happen was that pools “lost their gains.” One actually “closed its book by distributing stock to its members.” In the first half of 2005, the hedge fund game appears to have reached the same juncture. The S&P hedge fund Index gained just 0.13% in the first half of the year, and three funds “liquidated” in June: Baily Coates, Aman Capital and Marin Capital Partners. Due to a shortfall in trading revenues, Goldman Sachs’ quarterly profits fell for the first time in three years.
Some regulators see hedge funds “as beneficial, because they assist market liquidity and can dampen volatility.” In fact, this was Alan Greenspan’s position as late as May when the Financial Times reported that he “extols the hedge funds’ ability to make markets more efficient.” In June, however, Greenspan suddenly changed his tune. In an address to the International Monetary Conference in Beijing, he stated, “Most of the low-hanging fruit of readily available profits has already been picked by the managers of the massive influx of hedge fund capital.” “To hear from Mr. Greenspan, hedge funds are headed for a fall,” reported the June 10 issue of The Washington Post. The market was unfazed by these remarks, as the Dow rallied a couple hundred points over the next week. In mid-July, Greenspan offered an even more pointed assessment: “Risk takers have been encouraged by a perceived increase in economic stability. History cautions that the long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress.” Again, the market rallied.
The indifference is reminiscent of January 14, 2000, the day the Dow pushed to a new high that remains its all-time peak. One day earlier, Greenspan offered the suggestion that the rally “could be one of the euphoric speculative bubbles that have dotted human history.” The February 2000 issue of The Elliott Wave Financial Forecast had this to say about the remark:
"The market’s response to Fed Chairman Alan Greenspan’s latest warning signals a complete loss of respect for financial authority. Days later, The Wall Street Journal noted, “Stocks have historically taken a hit after Mr. Greenspan said something skeptical about the market. But more and more it sometimes lasts no more than a few hours. In this case, there was no hit at all.” In finally succeeding to tune out the sincere concerns of Alan Greenspan, the foremost financial hero of the bull market, the public has signaled that its potential to experience tragedy is now fully formed. "
The rally in the face of a Greenspan’s latest warning, his last major Congressional address, signals that Act III of the bear market is ready to commence. During the crash of 1929, the editor of The New York Times noted that the “surrender of the professional pools, though they believed their positions to be impregnable,” contributed greatly to the “successive convulsions” of the crash. He added that it was, however, “only proportional to the duration and extravagance of the period of illusion.” By this metric, the ensuing fall should outdo even that of 1929.
Ever-More-Exotic Tools of the Trade
As EWFF noted in May, a derivatives fiasco is likely to play a big role in the next phase of decline. In July, the New York Mercantile Exchange announced a new financial instrument that is so purely speculative that it may well mark the highwater mark for derivative “innovation.” The NYMEX now offers “same-day options” in natural gas and crude oil. Each morning’s option buyers can bet on what they expect the near-month settlement price to be at the end of the trading day. As Howard Simons at Bianco Research puts it, “The person who convinced the CFTC of the commercial need behind such an option is very underpaid.” Oil equities, shares of stock that trade based on the price of oil, opened on the London Exchange yesterday. The NYMEX and Philadelphia Stock Exchange are also developing similar “securities” that will trade based on the value of other commodities. Even commodities are equities now!
EWFF, December 2004
One common misconception in the marketplace today is that markets are awash in liquidity. What they are is rife with hedge fund operators who are not shy about leveraging the dwindling liquidity that still exists to drive markets from normal overbought or oversold levels to historically unheard of overbought or oversold levels. Conquer the Crash notes “hedge funds are only as good as their managers. Some fund managers use huge leverage and can “blow up,” losing everything on a bad bet.” One effect of the countertrend rally has been to populate the world with an overabundance of dangerously inexperienced managers. Back in June when the little guy investors were finally “given a crack at hedge funds” and the first German hedge fund was announced, EWFF called it “fair warning that the jig is up for hedge funds.” A recent study by two finance professors at Stanford and Princeton reveals what a few savvy observers already know: most hedge funds are nothing more than “momentum” players, riding whatever market is moving at the moment. The great hedge fund meltdown should start any day now.
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