Many apologies for delay in sending this week’s newsletter which has been due to technical problems.
Newsletter for w/c 3rd November 2008:
“Revenge is often like biting a dog, because the dog bit you” Austin O’Malley
Last week’s markets were characterized by an element of exhaustion as de-leveraging eased, allowing many instruments to bounce from extremely oversold levels while keeping volatility high. For example the German Dax bottomed Friday October 24th at 4014 yet by Friday 31st October was up to 5066, a rise of 26..5%. In the Americas both Brazil Bovespa and Argentina’s Merval fell to 29,435 and 819.36, their lowest in 3 and 5 years respectively, yet by the end of the week they had rallied 20%. By the end of the week, India’s Nifty was back to 2921 for a gain of nearly 30% within the same week. Commodities continued to make new lows as oil completed a 60% decline since its $147 dollar high back in July. Silver fell to 840 on the overnight market on October 28 yet 2 days later was back up as high as 1064, a 25% gain over 2 days.
It was against this background that the ambush (or short squeeze to give it its correct term) of hedge funds by Volkswagen, Porsche and probably the German government was an extraordinary event. Over 100 hedge funds collectively lost a staggering £24 (approx $40 billion dollars) on a doomed gamble that Volkswagen shares would continue to fall because of the global economic downturn. It was the “safest play in town. In fact Porsche had been secretly building up a 75% stake in VW via intermediaries which must have been particularly galling to the “hedgies” given Porsche’s iconic status as the car of choice for many in this industry.
Regardless of the legality of the move by VW and Porsche there was scant sympathy for the hedge fund industry who many have blamed for contributing to the current financial problems, not least in their aggressive shorting of financial shares.
However, whilst hedge funds can certainly be held to account for contributing to the current financial meltdown the reason it has all gone so horrible wrong is that most so called experts in this industry do not really understand risk and have been using (and still use) inappropriate mathematical tools and models to measure and manage risk. These tools and models are all based on the statistical device of the bell curve where the focus is on the norm, and any major departure such as a 1000 point drop in an index is seen as a rare event and its effect therefore negligible. Listening to an investment banker earlier this year explaining that the reason their housing price model failed was because it did not take into account housing prices ever falling, was sufficient evidence that this approach is now wholly inadequate.
For me one solution has come from the world of fractals and in particular the work of Benoit Mandelbrot and Nassim Nicholas Taleb, the latter being the author of “The Black Swan” which many traders and investors may have already heard of. Commonsense tells me that all markets are much more volatile than the experts would have us believe and that this past year has not been a “once a lifetime event” but something which can happen at any time. We have to accept that conventional measures of risk are not only outdated and outmoded but severely underestimate potential losses. For better or worse our risk exposure to huge losses is actually much bigger than we think it is. One only has to look at the risks when trading on margin where losses can exceed initial deposits to see this in graphic detail. Professional traders (or at least those who should know better) are often horrified at the leverage offered by most forex brokers. The maximum for retail traders should be around 1 to 5 or a maximum of 1 to 10 and yet the average offered by most brokers is around 1 to 100, up to a suicidal 1 to 400. If you are trading anywhere near these levels I would strongly suggest you stop and reconsider.
Trading Term: De-Leveraging: After a long period of loose lending by institutions who should have known better (some banks lending at 40 to 1 by using little understood financial instruments and fancy paperwork and then moving the details of their financial misbehaviour off their balance sheets where regulators could not see it) the reduction of this debt is now a number one priority and will be the cause of continuing turbulence. This has had a big impact on the currency market as many of the debts were incurred in dollars and yen. It is estimated that US investors alone were holding $5 trillion of foreign equities which are now being repatriated. It is this which has contributed to the recent surge of the dollar.
As more and more investors and traders enter the currency markets in an attempt to find better and faster returns it is important to understand that this market is going to be even more volatile and unpredictable. Also as it is also largely unregulated it is vital that anyone thinking of participating truly appreciates the extent of the dangers and risks inherent within it.
Good luck and good trading.
Anna