Why the credit crunch will hammer stocks as well as property
By
Dominic Frisby Jul 23, 2008
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Investors' enthusiasm for hedge funds has been curbed
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I had lunch with a leading hedge fund manager over the weekend. He didn’t want me to mention his name, but he was happy to admit – in fact he went on about it at great length - that he and many of his peers have a serious problem on their hands and there’s not a lot they can do about it.
That problem is redemptions.
Now, his fund has done well. He’s been long oil, long gold and short the stock market (sure, it seems an obvious position now, but it’s surprising how few took it). Yet many of his investors are pulling their money out. And in funds where the performance has been less impressive, the rush for the exit has been more dramatic.
Why are investors fleeing hedge funds? Perhaps to cover bills elsewhere, or perhaps simply because they’re panicking. And as we all know, the golden rule when panicking, is to panic first.
But this rush for the exits is taking its toll on stocks that have nothing to do with the credit crunch…
Why redemptions can trigger a domino effect
When you invest in most hedge funds, there will be a ‘lock-up’ period - a period in which investors agree to tie up their money and not make withdrawals. Once that period ends, investors can usually redeem their stakes at the end of the next quarter, provided they give enough prior notice, usually 45 to 90 days. But in June we saw a major rush for the exit.
The trouble is, this can trigger a domino effect. If a hedge fund has to return significant amounts of cash, the manager may then be forced to sell assets to raise the money, even if he would otherwise hold on to them. But this sell-off then drives down the price of the company he’s selling, which hits the performance of his fund, which makes more investors want to pull out.
Let’s look at an example.
RAB Capital has about $6bn under management. Their founders, Michael Alen-Buckley and Philip Richards, were considered two of the most astute investors around. They understood the industrial revolution in China and elsewhere in Asia, they foresaw the great boom in commodities, and they got in early. Without their funding, much of the boom in junior mining companies that we saw in the early noughties would not have been possible. RAB made millions. However, the decision last year to buy Northern Rock as it was in freefall put a sizeable dent in the company’s reputation, not to mention its bank balance.
RAB Special Situations (Aim:RSS) is one of their better known funds. It listed in 2005 at £1 a share. It's a closed-end fund, which means that even if you sell the stock, they don't then have to sell off a corresponding position in the underlying assets, unlike an open-ended fund. This means the fund will sometimes trade at a premium or and sometimes at a discount to the underlying value of the assets it holds (its net asset value, or NAV).
On July 8th, JPMorgan announced it had sold a million of its four million RSS shares. You can see what this selling has done to RSS. The fund has fallen off a cliff.
The fund is now trading at about 63p, even though it has a net asset value of 111p. That’s a big discount. It seems strange that JP Morgan would sell its position down so aggressively at such an obvious discount, but with the state that financials are in at the moment, the group may simply be keen to have as much cash to hand as possible.
The obvious trade for investors in RAB’s unquoted fund to make now is to redeem their position and buy RSS, the quoted fund. They’re effectively buying the same underlying assets at a big discount. But that would put even more redemption pressure on RAB.
How hedge funds are driving stock prices lower
In any case, one company that RAB had a significant position in is ICS Copper (CA:ICX), a nice little junior miner with some interesting copper assets in Zambia. But the Zambian copper plays have been badly beaten up this past year.
ICS has been on a near-relentless decline since August last year. In late June of this year ICS's sell-off accelerated and the stock almost halved in a few weeks, going from 40c down to almost 20c. This happened to coincide with the second quarter hedge fund redemption season and with JPMorgan's selling of RSS.
The stock has bounced this past week, as a group of funds and investors joined together to buy all the outstanding sell orders in the market. According to my sources, over 90% of the sell orders had come from RAB.
Now there’s no definite proof that JP Morgan’s redemptions led to RAB selling off ICS Copper, but the correlation is uncanny. In other words, pressure elsewhere that was nothing to do the performance of the company, sent a tiny East African copper miner to within 21c of zero.
So the credit crunch isn’t just hammering house prices. All the cheap money that hedge funds have been using to ‘gear’ up is vanishing too. And that means that perfectly sound stocks will be sold off as this credit contraction – which may become the greatest in history – results in borrowed money being pulled out of the market.
That means that despite the recent bounce, the bigger trend for equities is down. That won’t change – that is, we won’t get a proper bull market - until either credit becomes easy again, or until this whole debt-ridden mess is purged. If central bankers achieve the former without the latter, I dread to think about the inflation that will follow. If they don’t and we get the latter, then the future for Western markets could be very similar to that of Japan in the 1990s.
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Turning to the wider markets…
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UK shares turned down for the first day in four as the FTSE 100 index dropped 40 points, or 0.7%, to 5,364. Banks helped to drag the market down after poor news from the States about home prices and bad debts, with Royal Bank of Scotland and Lloyds TSB both sliding 2%, and Barclays and Alliance & Leicester shedding 3%, while HBOS sank 1.3% following its rights issue flop. Pub stocks dropped sharply, with Punch Taverns slipping 9% and Enterprise Inns plunging 13% on news of falling beer sales. But platinum producer Lonmin rose 5% on bid talk.
European markets did better, with the German Xetra Dax adding 0.3% to 6,443 while the French CAC 40 was unchanged at 4,327.
US stocks rallied strongly, despite some disappointing earnings reports, as oil prices slipped back. The Dow Jones Industrial Average put on 135 points, or 1.2%, to 11,602, while the wider S&P 500 added 1.4% to 1277 and the tech-heavy Nasdaq Composite climbed 1.1% to 2,304.
Overnight the Japanese market moved better with a 1%, 128 point, gain to 13,313 while in Hong Kong, the Hang Seng did even better, climbing 527 points to 23,054.
Commodity prices were generally lower this morning, with Brent spot trading down at $128, while spot gold fell to $939. Silver was trading at $17.73 and Platinum was at $1786.
In the forex markets this morning, sterling was trading against the US dollar at 1.9911 and against the euro at 1.2637. The dollar was trading at 0.6347 against the euro and 107.78 against the Japanese yen.
And this morning, mobile telecoms group Vodafone has announced plans to buy back £1bn worth of its stock, because the shares are "significantly" undervalued after dropping 14% yesterday.
Our recommended articles for today
Even as the American economy crumbles, you can still find solid investments in the US. The key is to buy companies who pay big dividends and own real assets, or who sell cheaply to price-conscious consumers.
Gold and silver are the ideal safe-haven investments to buy as a hedge against financial disaster. And with both precious metals underpriced when compared to oil, they still look to be good value.
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