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Here’s the chart that we discussed in the Hedge Fund Considerations section of this month’s issue of The Elliott Wave Financial Forecast. As the August issue points out, by flat lining at its all-time high, the S&P Hedge Fund index makes some excellent points about the hedge fund industry. For one thing, it shows how devilishly arcane these investment vehicle’s are. Standard & Poor’s can’t even keep track.

Most importantly, there’s the shape of the advance through the index’s discontinuation on June 30, which conforms to the rise in stock indexes, credit spreads, commodities and all the other components in the all-the-same-market scenario that was first described in Conquer the Crash (see page 2 of the June issue of EWFF for the latest chart). Elliott Wave International’s contention is that all of these markets have been riding higher on the same cushion of air. Our stack of 12 different indexes shows that the cushion actually sprang a slow leak back in late 2004 when the dollar reversed. In May, it reached the bulk of the affected averages. In June, EWFF stated that “final corroboration” of a turn would come when the S&P Hedge Fund turned down. Of course, when the S&P pulled the plug on its S&P Hedge Fund Index in late June, we were forced to add in August, “We won’t get that turn now.” But we added that the reason behind the discontinuation of the S&P index , “the collapse of the fund that provided data for it,” says volumes about the status of the industry. It shows very clearly how fast hedge fund fortunes can disappear.

With this and the post-peak backlash against the most efficient exploiters of the preceding advance (see Investor Psychology section of this month’s EWFF) in mind, EWFF is forecasting a big bull market in hedge fund regulation. The seeds of a such a drive are evident in another L.A. Times story, “Hedge Funds Draw Concerns.”

The articles quotes Sen. Paul Sarbanes (D-Md.) saying, "You have this uneasy feeling about a whole area here that we don't know very well." The SEC voted last year to require most hedge fund advisors to register with the SEC to allow for greater oversight. But a U.S. appeals court threw out the rule June 23. It’s no coincidence that on June 30, the hedge fund index hit its all-time high; as long as the air is rushing in, the recriminating forces are held at bay.  At hearings last week, SEC chairman Christopher Cox “stopped short of pushing for new legislation” that would give the SEC the power to oversee the hedge fund industry. With no "clear definition of a problem" or "evidence showing how the regulation would improve financial market efficiency,” John E. Sununu (R-N.H.) said the appeals court was probably justified in tossing out the SEC's proposed rules. Treasury Undersecretary Randal Quarles,  also testified that it would be premature for Congress to introduce new legislation regulating hedge funds.  A presidential panel of banking, securities and commodities regulators has been formed, but it's not recommending any direct regulation of hedge funds either. “If evidence emerged that indirect regulation wasn't working to constrain the amount of debt funds took on in pursuit of high returns, then direct regulation of hedge funds could be considered,” says the group.

In other words, despite an overwhleming sense of foreboding, government can't do anything about a hedge fund blow up until after hedge funds blow up. The situation  is developing into one of the all-time great examples of how government operates as “the ultimate crowd.” With the wide range of leverage bets in many of the riskiest financial markets, any government legislation designed to forestall or mitigate hedge fund collapse will come way too late (and probably do more to dampen investment than effectively control future problems). It’s a strictly psychological dynamic, but it is unfolding so clearly  now that it seems like a physical law; government literally waits for the horses to exit the barn to slam the door shut.

June 2006 EWFF
The June 2005, EWFF identified hedge funds as a “key player in the reflation levitation.” EWFF also noted that hedge funds serve essentially the same function as the “pools and syndicates” did at the Supercycle peak in 1929. They are super-organized investment groups with access to vast amounts of leverage. By piling into many of the same markets at the same time, they jam some of them higher. But the initiation of wave 3 down says that it is time for them to lose any grip that they may have on the markets. The following article from May 13 shows that chaos is poised to wrest power from the hedge funds:

Banks Face Vast Losses in Copper Mayhem
The spike in copper prices over recent weeks has left a group of banks and operators on the London Metal Exchange nursing vast losses, raising concerns about the stability of the commodities market.
—The Telegraph, May 13, 2006

David Threlkeld, a copper trader who helped blow the whistle on the Sumitomo copper scandal in 1996, says that hedge fund speculation has driven copper prices way beyond fundamental value. Near last week’s peak, things were so out of whack that there was a whopping $5097 per tonne discrepancy between the near-term 3 month futures price ($8875 a tonne) and the April 2011 long-term futures price ($3778 a tonne). “The LME has been seduced by hedge funds, [which have] pushed prices to levels unsupported by fundamentals,” Threlkeld said. “The crash could set off a chain of margin calls running through the whole commodities sector. We’ve got a crisis on our hands, and it is a lot bigger than copper.” As we noted last week, at the end of every bubble, the marketplace always seems briefly to glimpse its fate. After the peak of the Great Stock Mania in 2000, other even riskier realms were available to investors. This time, all markets but cash should be locked in decline.

March 2006, EWFF
In a perfect world, everyone would have his own hedge fund, and the stock market would drift higher forever. In the imperfect estimation of this newsletter, however, there are limits to how many hedge funds and how much higher and longer the Dow Jones Industrial Average can rise. Based on a clearly defined wave pattern and several key timing tools, The Elliott Wave Financial Forecast believes those limits are at hand.

February 2006, EWFF
Hedge funds stand to be a main ingredient in the panic. Many didn’t even blink when the Japanese exchange shut down with 20-minutes of trading still to go on January 17. Apparently they just see it as a buying opportunity. “Because hedge funds have been big players in Japan, one might expect the trouble in Tokyo would have them yelping in pain. Instead, it has got them drooling like Ivan Pavlov himself was ringing the bell.” But even as hedge funds’ investment orders up the ante, the industry’s asset base is starting to erode. According to the latest figures for the fourth quarter, investors withdrew more than they put in to hedge funds for the first time in 10 years. In a bid to stem the tide, The Wall Street Journal reports that Citadel Investment Group, one of the investment world’s most prominent hedge-fund operators, is pulling “Up Its Withdrawal Bridge as hedge funds Aim To Block the Exits.” “Hedge funds are cracking the whip to keep investors in the fold.” We have a guess as to why investors are pulling out assets: the same reason they’re pulling “equity” out of their homes; they need the money.

Hedge funds will fail in the attempt to keep assets because the unfolding third wave and deflationary crash hold the potential to bring the biggest liquidity squeeze in history. Evidence of its emergence is now popping up across the breadth of the hedge fund industry. A few weeks ago Centrix Capital also started limiting customer withdrawals “to keep institutional investors from fleeing.” Centrix packages sub-prime auto loans for which there is no liquid market. “The sudden rush for the doors is a result of two of our larger investors needing to raise cash at once, for their own reasons.” One of the options being discussed is to pay investors back “in kind” with the loans in its portfolio. This is going to be a sight: “Sorry, Mr. Fund Investor; we don’t have your money, but here are some I.O.U.s on used Cavaliers and Focuses in Arkansas. Maybe you can collect. Good luck!” Welcome to the new investment world where bad paper, systemic breakdown and “I’ll pay you next Tuesday” will be common themes.
In Germany, Deutsche Bank took “the unprecedented step of freezing one of its so-called open-ended” real estate funds. The $7.2 billion fund was “frozen” on December 16 “to prevent a run.” It was the first such move in the 40-year history of property funds in Germany. The closure sparked anger and the threat of lawsuits. This is only the beginning. In addition to the reversal in assets, the wide range in the estimates of the average hedge fund’s performance in 2005 hints at another potential problem. The aggregate figure ranges from 2.3% to 9.4% depending on whom you ask and whether defunct funds (which accounted for 6% of the industry in 2005 alone) are included in the tabulation. Business Week says the annual return is only a guess because “some ne’er do well funds might overstate results.” With so little oversight and so much pressure building, the predicament of even the most upstanding hedge fund manager calls to mind the Lehigh University sophomore who played second cello in the university orchestra and worked in the chaplain’s office. Due to his addiction to poker, he ended up robbing a bank. When panic sets in, history shows that the urge to lie, cheat, cook the books and do whatever it takes to stay afloat seduces many. The first leg of the bear market attests to the scandal-generating capacity of this Grand Supercycle bear market. Temptation will get the best of many overwhelmed hedge fund managers. With more than $1 trillion in assets to manipulate, it should be no small affair. Move over Enron, Tyco and Martha Stewart; the really big scandals are ready to start popping.