Wednesday, November 5, 2008

Trying To Make Sense

My yesterday's post was wrong. Instead of crying, I should keep trying.

Current picture, collected from bits and pieces of information: funds got mad. By the way market reacts, significant percentage of them. That includes hedge funds, mutual funds, university funds, state pension funds, i.e. all kind of them. Looks like many funds use methods developed by hedge funds in order to increase performance, "beat the market". The biggest problem with this approach, as Jim Cramer noted in his great book "Confessions of a street addict", is that you can't beat the market if you are the market. And many funds behave the same way, buy and sell things (stocks, bonds, commodity contracts etc.) at the same time. We can see the results of this behavior in the commodities run in the end of the last year and beginning of this one, huge downfall of stocks in September-October and last week rally.

Of course, not all funds are doing the same thing. But you only need about 10% of participants to behave the same to screw up market. So, when hedge funds started liquidating after Lehman Brothers collapse, stocks went down huge. When pension funds felt that oil is going down and there is no force in the world to keep it above $120, they sold everything.

Of course, there is a huge problem here for the funds themselves. If fund calls itself "hedge fund", it can't have huge one-sided positions. It needs to hedge positions, buy options to defend long or short positions, sell 6 months ahead future contract if they buy 4 month one etc. But you need to do a lot of work and performance would suffer. So they try to find current trends and play them. The problem is, when funds are the market, or at least the active part of the market, they magnify any trend they are in and create bubbles.

How can we profit from it? Tough, but not impossible. We need to identify bubbles and short them when they are bursting and identify severely oversold stocks which don't deserve it. I did it with oil in the end of July and beginning of August (sold DTO too fast, granted, but made profit anyway). Another approach is to detect trends which are not obvious for other market participants yet, like I did with dollar. I'm still holding UUP, but now looks like time to sell. We'll see. I don't allocate big part of my portfolio for such trades, until last year I was pure long term investor, but this market is not for investors. I think of allocating more of capital for trades from investment.

Full disclosure: at the time of publication author had a long position in UUP and no positions in other stocks mentioned. Positions can change any time.

Disclaimer: This article is not intended as an investment advice. Every person should make her/his own investment decisions based on all available information and advice from her/his own financial advisor.

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