If you're baffled by Wall Street's performance this past week, consider the increasing influence hedge funds have in manipulating the market.
Investors spent another anxiety-ridden week watching last-minute triple-digit swings in the Dow Jones industrials, driven in part by worries about credit drying up and further subprime mortgage losses. But, while it looks like the market gyrates solely on fears about credit issues, market watchers say it is more complicated than that.
The Dow's 104-point drop in the final 15 minutes of Friday's session clearly had its roots in fundamental issues — comments from Bear Stearns Cos. executives that reignited fears of a widening credit crunch. But that drop, the 150 point sprint higher in the last 20 minutes of trading on Wednesday and a similar 100-point advance on Tuesday, might also have technical reasons behind them.
Hedge fund managers have been making bets on how far down or up the market will move in a given day by making sophisticated "short" and "call" investments. But the market hasn't always cooperated — going in the opposite direction from what hedge funds have expected and leaving them to scramble at the day's end to cover positions by buying or selling stocks.
"This is how hedge funds and the big proprietary trading desks on Wall Street make their money," said Peter Cohen, president of Massachusetts-based consulting and venture capital firm Peter S. Cohen & Associates. "For the individual investors, they are completely out of the loop and along for the ride."
This catalyst for this new breed of volatility has been the market's increasing anxiety amid a continuum of dour headlines about faltering subprime debt and the erosion of leveraged buyouts. But it makes for an almost perfect trading environment for hedge fund managers who thrive on volatility.
Most of the activity can be seen in exchange-traded funds, especially those that track the Standard & Poor's 500 index. Hedge funds and mutual funds also rely on electronic trading systems that automatically execute trades based on algorithms, and that was also seen as a reason for the late-day surges.
Analysts believe this kind of a pattern is bad for the market — and should be discounted. Hedge funds now account for half the daily volume on the New York Stock Exchange, with average volume this week running about 2 billion shares.
"This is all noise, you have a bunch of lemmings that run left and right and up and down," said Roland Manarin, a portfolio manager who runs Manarin Investment Counsel. "It is when an absolute panic is going on that investors should get a second mortgage and diversify among stock investments. You just can't follow along with everyone else."
There was plenty of news to rattle hedge funds this past week. On Wednesday, American Home Mortgage Investment Corp. collapsed from exposure to loans made to investors with shaky credit; and mortgage insurers Radiant Group Inc. and MGIC Investment plunged because of wrong-way bets on securities tied to subprime loans.
With the collapse of two hedge funds managed by Bear Stearns still fresh, the market was also unnerved by rumors that hedge fund Caxton Associates LLC, a $12.5 billion fund run by Bruce Kovern, was said to be facing margin calls from a number of brokerages because of steep losses.
"These kinds of things create an environment for people to generate profits on a short-term basis, working off of fear and greed," said David Grenier, president of Cutler Capital Management, which operates three hedge funds that focus more on a buy-and-hold strategy than on trading short term. "This kind of market allows some hedge funds to test their strategies with index funds, and the guys sitting with exotic strategies are more willing to wheel and deal in this kind of volatility."
Economists have predicted that the implosion of a few more hedge funds could create a panic on Wall Street, similar to Long-Term Capital Management's failure in 1998. For those trying to make money in the current market, shorting stocks ahead of such a shock could unlock millions of dollars in profits
It might be one of the reasons that Caxton acted quickly to offset what it called unfounded rumors in a letter to investors. The hedge fund said it has posted losses of about 3 percent in its flagship Caxton Global Investments fund last month, but is still up for the year.
But, in the meantime, the market rumors and unpredictable swings are causing some fatigue for portfolio managers and floor traders. "I don't know how long this can go on before some of these traders hit the breaking point," said Peter Dunay, an investment strategist with New York-based Leeb Capital Management.