Wednesday, October 8, 2008


What was the selling Tuesday on Wall Street all about?

On Monday, the market spent most of the day going down, but had a significant uptick in the final minutes.

But then yesterday ... boom. The Dow, the S&P, and Nasdaq all declined by more than 5% of their total value which, in the case of the Dow, amounted to more than 500 points.

As usual, the pundits have their theories:

1. The big one-day decline was a response to an announcement from Bank of America that it was cutting its dividend, or
2. It was a reaction to a rumor that MUFG is pulling out of a deal to acquire a large chunk of Morgan Stanley, or
3. Bernanke scared the traders with his mid-day statement, or
4. all of the above and other stuff.

None of that looks persuasive to me. One can hypothesize that one of those butterflies caused this hurricane, but I think there's a much larger wing than any of those flapping about.

Call this the hedge fund capitulation. Hedge funds have lock-up periods, sometimes for months at a time. As the term suggests, hedge funds are by design illiquid. An investor, having put his money in on Monday, can't simply say, "I've changed my mine, I want to liquidate my interest" on Wednesday.

Well, actually, he can say it on Wednesday if he wants, but he can't expect the managers will act on that demand any time soon thereafter. They're entitled to wait until the lock-up period has expired, i.e. that the "redemption" date has arrived.

This can have a systemic impact on the markets because it is natural for hedge fund managers and investors to agree on the end of a financial quarter as the redemption date. Much of the hedge fund industry was committed to allowing hedge fund withdrawals on October 1, AND much of the industry had just had a lousy third quarter, making it very likely that they'd receive demands by September 30.

Those hedge funds that didn't have enough cash hanging around in the office furniture to meet the redemption demands they've just received have taken to selling shares of stock to obtain the liquidity needed to pay off these exiting investors. Hence the downward pressure we've seen of late.

I call this the hedge fund capitulation , because the italicized term is used in finance-world jargon to mean a particular sort of crash -- one with a valuable cleansing effect. It means the final shuddering sell-off after which everybody who can be scared away has been scared away. All the selling likely to be done any time soon will have been done, and a floor established.

October 1987 saw a capitulation. The Dow lost 20% of its value in a single day. Within 1.5 years, it had returned to the pre-crash level.

We didn't have 20% at one clump this time, but the market has lost almost that in about two months. But as August of this year began, the Dow was at 11,500. It is now at 9,447, which is about 18%. Let's hope that's enough, and that with the final kicking-in of this hedge fund liquidation component, capitulation has been accomplished.

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