Strategy is about making choices, trade-offs.
Over the past few days, I have received several calls from clients asking similar questions. So, I want to take this opportunity to provide what I hope is a comprehensive response in case you have similar questions.
Excessive Hedge Fund Leverage
Since my last post it has become more evident that several hedge funds have been overleveraged, likely in attempt to maximize performance returns over the short-term. (To read a brief definition of what a hedge fund is, please click here). These hedge funds have been wrong with their investment opinions and have suffered significant investment losses.
This is what I meant when I referenced this being a liquidity crisis in my previous post. The use of leverage has caused them to face margin calls, forcing them to sell any and all financial assets to meet those margin calls. This is part of the reason why this decline has been so swift and ferocious.
I believe the good news is the selling is clearing out the leverage, and when complete, may eliminate a significant source of the current selling. At some point, I expect the stock market to experience a price bounce, which may be beginning today. However, this does not necessarily mean stock prices are going to rise straight up from here. Let me explain.
Understanding deleveraging and forced liquidations
I believe there are at least two aspects of this market you need to understand. First, several hedge funds are closing their doors and going out of business. Others have stopped allowing investor redemptions at this time and intend on selling remaining financial assets over time to return money back to fund investors.
Second, unlike hedge funds who can prevent shareholders from making redemptions, mutual funds cannot. When investors want to sell their mutual funds—for whatever reason—the fund must return their money. So, when some investors panic and place orders to sell their shares, it may cause a negative impact on every investor in the mutual fund. The mutual fund manager may not want to sell, but if they don’t have enough cash to meet redemptions, they have no choice, and are forced to liquidate investments at lower prices. This is one reason why I have not been a fan of some mutual funds for many years now. If this happens, the fund is not left with any cash to buy into the market at lower prices unless new investors add money to the fund through new purchases.
Understanding Investor Psychology
When the stock market experiences a price “bounce” from a price low, investors are likely to react differently. For instance, the hedge funds who are desperately trying to eliminate their margin calls and leverage would like nothing better than a rising stock market to sell into. So, if a price rally occurs, it may be temporary and met with additional selling. Some mutual fund investors who are scared may be inclined to sell more shares on a price bounce out of fear the market may continue to go lower. But those investors who have limited their losses will want to buy in at what they hope to be lower prices.
Remember, as profit-seeking investors, we must consider the psychology of other investors as we consider our own investment decisions.
With our strategies currently invested as they are, we have options. One option to consider is to look for a potential bounce, should one occur, and buy additional inverse ETFs at higher prices, if, and only if, we believe prices will continue to decline thereafter.
Alternatively, if prices continue to decline, a different option is to begin selling inverse ETFs and cash equivalents and accumulate stocks, attempting to fulfill the “Buy low” part of “Buy low, sell high.”
Finding “the bottom”
One long-time client asked recently how to identify “the bottom.” Unfortunately, without a crystal ball, we can’t. However, there is a pattern that I have observed and documented that happens from time-to-time in the stock market, that at least suggests the likelihood of a price low. This pattern occurred during the 1987 stock market correction and at the 2009 price low, in addition to other price corrections over the years. While there are no guarantees the pattern will manifest during this decline, it is what I will be diligently looking for over the coming days and weeks as I consider additional investment decisions.
Remember—our strategies have so far limited investment losses compared to the broad stock markets. This could allow us to eventually recover these losses without the need for the stock market to go back to their recent highs. I don’t believe we have to find the bottom—we just need to look for evidence that the likelihood of a low has taken place. This could help us make more profitable investment decisions going forward.
Thank you for reading this special update, and please do not hesitate to call (833) 258-2583 with questions or concerns.
BLUE LINE INVESTING® (BLI) is an actively managed investment process that pursues our mission by combining a trend following investment philosophy and a “buy low, sell high” investment strategy. Our mission is to grow our client’s financial wealth over a full market cycle in a risk-managed and tax-efficient way.
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