Markets R.I.P: The Great Unwinding

Pensions & Investments magazine warn, “Bloodbath Ahead.”

Reuters predicts, “D-Day for Hedge Funds as Redemptions Roll In.”

CNN cautions, “Hedge Fund Blues are Just Beginning.”

The markets sit perilously on the edge of disaster. A downward spiral is getting stronger and there’s not much that can be done about it. And one of the leading has been and will be hedge funds.

Frankly, the consequences can be dire if you’re holding the same stocks as the funds. The news isn’t all bad. As you’ll see in a few moments, the mass sell-off will create a few stellar short-term and long-term opportunities in three specific areas.

You see, hedge funds have been around for decades. They were originally set up for wealthy investors to participate in more exotic investment strategies. The funds chased after small market anomalies to try and beat the markets. There were rules in place to ensure only “accredited” investors could get in them.

The assumption was that accredited investors would be more patient and understanding of taking losses. They would be able to have their money tied up for longer. Volatility was part of the game. If you had $1,000,000 in assets or $200,000 a year in annual income (or said you did – the background checks were about as in-depth as the ones mortgage lenders used), you would understand that markets go up and down and wouldn’t demand your money back.

Well…as we’ve learned with a lot of other assumptions made over the past few years, they couldn’t have been more wrong. After watching the markets wipe away $19 trillion in wealth so far this year, hedge fund investors are calling for their money back. They are redeeming at a record pace.

The redemptions are playing a big role in the current market selloff. And they could spark the next round of a disastrous spiral.

It goes like this. A few investors say they want their money back. A hedge fund has to sell what it can to pay them back regardless of how bad the timing may be. They are forced to dump shares onto a market with very few buyers. The market slides even more. That slide leads to more fear, more redemptions, more selling, and on and on.

Normally any single fund unwinding its positions can be absorbed by a healthy market. But the market isn’t healthy. And if just a small percentage of the 9,000 hedge funds with more than $1 trillion under their control (and a lot more borrowed money that needs to be unwound) push the sell button at the same time, the impact on the markets can be huge.

Over the past few weeks a lot of them are pushing the sell button.

Hedge fund performance is down…way down. Eurekahedge, which tracks hedge fund performance, says less than one in 10 funds of the 4,000 it tracks are in positive territory. Even Maverick Capital and Greenlight Capital, two former top tier hedge funds, lost an average of 16.1% according to Bloomberg.

Hedge funds are falling apart. And investors are demanding their money back in droves. It’s getting so bad a record number of hedge funds are closing up shop altogether.

There are some big funds that have to sell out completely. Sowood Capital Management recently closed its doors after dumping what was left of its $3 billion in assets. The $2.8 billion commodity trading fund Ospraie closed its doors after its value fell 40% in August. Two Bear Stearns multi-billion dollar hedge funds practically took down the entire firm.

And those are just a few of the big ones. Hundreds of smaller funds are going through equally tough times. CNN reports, “By the end of the year, it’s estimated 679 funds will be shut down.”

They shut down and liquidated.

The spiral continues…

That’s why I recommend watching the following sectors very closely. Any more sell-offs from hedge funds can send these sectors plummeting even further. I realize most are down 60% or more, but it wouldn’t take much to fall another 20% to 50%.

Hedge Fund Sell-Off Opportunity #1: Emerging Markets

Emerging markets have been a bastion of hedge funds for years. The outsized returns offered by emerging markets have attracted a lot of fast money. For five years, a hedge fund manager could buy an index fund (borrow money to leverage up) in virtually any emerging market and watch his performance soar 40 to 60% each year. Then he could tell investors in his fund how great a stockpicker he is because he beat the S&P and the local indices.

It was a great strategy…for a while. The party had to come to an end sometime. And that time is now.

Emerging markets have gotten rocked. The mighty BRIC wall has come crumbling down and has brought dozens of hedge funds down with it. For instance, GWI Asset Management, which manages a fund focused on Brazilian stocks, is down more than 50% in the first nine months of the year.

Hedge Fund Sell-Off Opportunity #2: Agriculture

Agriculture sector stocks are still reeling from the hedge fund sell-off. After a fantastic run from 2006 through August 2008 the ag sector caught a lot of attention…and buyers.

Everywhere you turned, there were “experts” touting how the world is running out of food. There won’t be enough.

The story was perfect. Investors expected this to be the biggest boom of all.

Now, I first recommended buying fertilizer stocks in the summer of 2006. It was a great time to buy and we had a fantastic run. Of course, the run would not have been nearly as great without the help of the hedge funds piling in for two straight years.

When the markets first started to crack near the end of summer, we knew agriculture stocks would be hit hard. After more than a year and a half of the hedge funds buying and buying, they would have to sell. And given the state of the markets and record redemptions to meet, they would have to sell at practically any price.

The end result is we have agriculture stocks selling at drastically low valuations. Some of the highest quality companies that practically mint cash and are relatively immune from a recession are selling at fire-sale prices. Anyone caught in the sell-off easily could have lost 60% or more even though they focused on quality.

Hedge Fund Sell-Off #3: Commodities

The final hedge fund favorite over the past few years has been commodities. Again, it’s the same story. Hedge funds looking for big returns were chasing after anything that goes up. Over the last few years commodities and mining stocks have been top performers. That attracted a lot of buying. As they went up, more and more buying came in. They went up more…and on and on.

This went on for years. But once the sell-off started and the funds started to have to raise cash to meet redemptions, it was time to sell. And when everyone sold at once, it’s pretty easy to see the impact.

The impact of the sell-off has been big. More than $19 trillion of global wealth has been eliminated this year. U.S. retirement accounts have shed more than $2 trillion in value so far this year. And if the redemptions continue, there will be more selling pressure. At worst, the pressure could be strong enough to sink stocks even lower. A best, selling pressure would probably limit the upside of a rally.

There is a plus side to all this. Once the aggressive selling is over, shares in these sectors could go on an absolute tear. There will be some fantastic buys amidst the rubble when the smoke clears (Quite a few great buys are already starting to pop up in stocks).

But I’d wait to see an uptrend before stepping in. Remember, stocks go down a lot faster than they go up. And right now, trying to catch the bottom just to get the first 10% or 15% of a steady climb isn’t worth risking a further slide of 50% or more.

If you’re looking for the long-term, the best place to be is still on the sidelines. It’s OK not to buy stocks today.

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