Technical Sell-off Equals Tremendous Opportunity

When the economy is deteriorating, corporate earnings tend to decline, and the real values of stocks fall. Lower stock values justify lower stock prices. But there are other things outside of value that could cause stock prices to fall. In fact, many argue that these “technical” factors are forcing stock prices to fall well below what they’re actually worth. This difference between a stock’s price and value is called alpha, and if you invest correctly, you make money as this gap between stock price and stock value closes.

Let’s run through a few non-value, or technical reasons why stocks may be trading below intrinsic value.

Panic Selling
If you’re invested in stocks, you hate to see prices fall. Many people will sell stocks, giving no thought to value, because they don’t like the possibility that a stock may fall further; they become risk averse. Unfortunately, the act of selling causes stocks to fall. In other words, panic selling causes stocks to fall further, which induces more panic selling.

When you sell your mutual fund shares or reallocate your 401k plan to hold less stocks, you are selling stocks. High net worth investors have been cashing out of hedge funds as well.

Margin Call for Average Joe
Brokerage firms allow people like you and me to invest on borrowed money, or margin. Investing on margin is referred to as leverage. Brokers will lend you up to a dollar for every dollar you have. However, if you invest on margin and your investments fall, your broker will force you to put up some more money. This is known as a margin call. But what if you don’t have the cash? Well, you’re gonna have to sell some of those stocks, whether you like it or not.

When the stock market falls 40%, you can bet a lot of these investors have received margin calls.

Margin Call for Steroid Joe
Hedge funds have special relationships with brokerage firms. Their brokers are called prime brokers. Because of this special relationship, hedge funds get to borrow even more money. Some have been known to borrow $30 for every dollar.

Let’s say a hedge fund is borrowing $10 for every dollar. If the fund’s investments fall 10%, then that hedge fund is effectively worth nothing.

Hedge funds are getting their margin calls. Many are shutting down their shops completely (i.e. liquidating their assets). All this equates to a shit load of selling. Some experts have attributed 300 point swings in the Dow to hedge fund liquidations. Unfortunately,this is hard to prove because hedge funds keep their trading activities secret.

Deleverage
Even if a hedge fund has been successful, prime brokers and banks realize that allowing huge amounts of leverage is too risky. Leverage is part of the reason banks like Lehman Brothers have gone belly up. As a result, everyone is deleveraging. In other words, they are selling stocks and returning that borrowed money.

Sitting Ducks
Then there are successful hedge funds who are in great financial shape (e.g. reasonably levered) and they're making money, but they’re selling their investments anyways. It’s hard to estimate how much of this is actually going on. Anecdotally, it’s rumored that the SAC Capital, a $16 billion fund led by the most successful trader alive, has 50% of his firm assets sitting as cash. Ken Griffin's $18 billion Citadel Investment Group is 30% cash. John Paulson’s $35 billion Advantage Plus Fund, which has made billions of dollars betting against the market, is currently 70% cash.

It’s hard to know why they are doing this because hedge funds are highly secretive. One reason may be redemptions. In other words, fund managers are expecting some of their investors to cash out. As such, these hedge fund managers want to have cash on hand.

Or maybe they think the market is too risky. Hedge funds have a reputation for being extreme risk takers. But they’re not playing the market!!

It's Not You, It's Me

It's not the company value thats pushing stocks down; it's the investor.

In My Opinion...

Stock prices reflect an extremely terrible future for our economy. As you know, I have a pretty negative outlook. But, based on valuation backed by my negative expectations, I believe stocks seem extremely cheap.

I think technical factors have caused prices to fall well below value. In other words, I believe there is tremendous alpha in the stock markets. I have no idea where the stock markets will be over the next few weeks or months. I think in the near term, technical factors will be partially responsible for wild swings. Eventually, these technical factors will dissipate and the markets will work more efficiently. But by that time, you will have already missed the opportunity.