Government rescue of hedge funds is not going to happen

Foreign Exchange Outlook :

We keep running into some remarkably foolish commentary now that the world has blown up.

Stratfor claims that it can predict economies without actually knowing any economics, which a little like taking stock tips from the shoeshine boy, isn’t it? It predicted the Russian invasion of Georgia, which had no real effect on global markets and doesn’t pass the “so what? test. Even if you can see the broad outline of upcoming events, that doesn’t mean you know how to trade it. Trading skills are entirely different from macro analytical skills.

Probably the most foolish idea of all is that those nasty hedge funds are going to get their comeuppance, with 30% of them failing (Credit Suisse). According to the WSJ, this is the worst year ever for hedge funds, collectively down 5.4% in September and 10.1% for the year (which is still better than indexing to the S&P, down 20% over the same period). This is because banks are pulling back credit and the funds have to reduce leverage, which means they must sell positions in everything-stocks, bonds, commodities, alphabet soup paper, currencies. That’s on top of having to sell positions to repay investors, most of whom had to sit through a long waiting period to get their money back.

We don’t deny that the contraction everywhere in the financial universe will cause hedge funds to contract, too, but we object to the imposition of a value judgment on the hedge funds as somehow predatory. A good hedge fund offers some protection against the market dropping—the original raison d’etre of hedge funds-which means the investor is prudent and conservative. That’s a good thing, not a bad one. Hedge fund investors include giant massive pension funds, for example, as well as the savings of rich folks. As a value, we’d rather pension funds invest conservatively than be out flailing around speculatively, don’t we? Hedge funds are systematic, too, another good thing. The only thing we can really complain about is leverage, and that’s certainly the pot calling the kettle black. There is not a single financial entity out there not using leverage except maybe Aunt Millie, who doesn’t have a credit card and has paid off the mortgage.

We are not convinced that things have changed forever, government intervention or not, and will be convinced only when all governments everywhere agree to regulate leverage. (Even then the leverage-seeking can find haven in Jersey or somewhere.)

We know that Long-Term Capital had leverage of about 30x and Bear Stearns, 35x. But like the rain falling on the just and the unjust alike, the involuntary contraction of hedge funds due to deleveraging will wreak havoc across the whole industry. It is not necessarily true that the funds left standing will those the least leveraged-a highly leveraged fund can do better than a lightly leveraged one if it was invested in the right stuff. It’s wrong to take joy in the destruction of the hedge funds-that’s somebody’s retirement going down the drain. Unless you want the public to fund all retirements with government plans, we should be figuring out ways to help the hedge funds, too, not cheering their demise.

Government rescue of hedge funds is not going to happen, of course.

In fact, Paulson said there would be no money for “unregulated” companies, presumably referring to hedge funds but also perhaps with a gimlet eye on others—auto companies? Therefore, the fate of hedge funds-whether 30% fail or 80%-depends on when prices stabilize in financial and commodity markets. We should assume that hedge fund managers really do know something the rest of us do not, including timing the economic cycle. TrimTabs, which tracks hedge funds as well as mutual funds, says hedge funds sold $43 billion in September and perhaps as much as $50 billion in Oct. “In many cases, the funds seemed to be raising cash preemptively,” says a TrimTabs executive. Hmm, “preemptively.” Does that mean rejigggering portfolios in the newly deleveraged environment is a worthwhile exercise? Of course. And it also means being less defensive. Gold and cash are both a crummy “investment.” They have no intrinsic yield and the opportunity cost is high. As Warren Buffett says in the NY Times, "Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value." Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: ‘I skate to where the puck is going to be, not to where it has been.’ Buffett is putting his personal money, previously all in Treasuries, into US stocks.

The other big Event to look forward to is the overall calming of panic and frenzy. Alas, panic and frenzy are US dollar -favorable. As the TICS analysis above shows, demand for dollars is an emergency thing. When things go back to normal, this demand will evaporate, and the US will have an unfunded current account deficit. The Middle East and China are sitting this one out, showing not the slightest inclination to rescue anybody. Unless everyone follows Buffett’s advice and the US stock market recovers lustily, we can’t count on foreign capital inflows to balance the deficit. Besides, the dollar exchange rate is not highly correlated to the stock indices. This is the nightmare scenario that so many doom-and-gloom analysts have predicted for so many years.

We take comfort and a strong US dollar exchange rate scenario from the idea that while screaming panic may be gone-overnght LIBOR at 10% for European banks is screaming panic-anxiety is not gone, and rightly so. The bailouts can fail. The bailouts can be insufficient and cause governments to pony up even larger sums. Other companies and industries "too big to fail" can emerge, like the auto companies or insurance companies or perhaps a black swan. The recession can be bigger, deeper and longer-lasting, and hurt other economies worse than the US.

We are sticking with the strong US Dollar scenario a bit longer.

Buy for Now

Barbara Rockefeller
Forex Trading Reports

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