"Live To Fight Another Day" - One Hedge Fund Trader Explains What Is Driving The Collapse

Authored by Nick Colas via DataTrekResearch.com,

Earlier today we ran into a former colleague who now serves as a risk management consultant to the hedge fund industry. I can’t tell you much about this person for obvious reasons, except to say that they fit the classic definition of someone you should listen to: they talk to the right people. And, even more importantly, the right people pay our gal/guy for their views.

Over the course of a wide-ranging conversation, we gleaned the following from “Lou” (what we’ll call our source):

On Wednesday’s meltdown: hedge fund de-risking drove much of the late-day selloff. This makes sense to us for two reasons. First, Tech led the way lower and that’s been a popular hedge fund trade all year. Second, no one sells a down 2% day unless someone is telling them they have to reduce risk immediately.

On Trump and the Fed: Lou feels that President Trump’s increasingly critical commentary regarding Chair Powell’s rate hikes is causing part of the latest bout of US equity market volatility. Essentially, the Fed may have to raise rates further than justified just to prove their independence. And that’s not good for the Fed, the President, or the US economy and capital markets.

US midterm election: Lou is concerned that US equities will remain volatile into midterm elections on November 6th. It is a hard event to position for in hedge fund land. If the Republicans do manage to hold on to the House, US stocks should rally (so you don’t want to be too short). If the GOP loses the House (as expected), the market response is uncertain (and you won’t want to be too long). Asset prices may even head lower depending on the magnitude of the GOP loss and the rhetoric coming out of the Democrats.

Also in the mix: mid quarter redemption notices from hedge fund investors, due by November 15th. It has been a hard year to have a differentiated investment edge, and many funds are doing poorly. Even more so after yesterday’s forced selling, by Lou’s approximation. Some funds are even worried about their survival if they receive too many redemption requests.

Lou’s odds of a new 2018 low for the S&P before the end of the year: higher than 30%. Like all good risk managers she/he has no structural view on equities, but rather assesses the tape as it comes. Lou is advising clients to be very cautious just now and not try to call a “V bottom” but rather take down exposure (long and short) and live to fight another day.

In the end, we took away three conclusions from our time with Lou.

#1. US equity hedge funds still have the market influence to set closing prices and drive market volatility. Keep in mind that smaller funds (and there are thousands) can flip positions on a dime. The same people selling Tech into the close yesterday might have bought today’s open.

#2. Since many funds are flat or even down on the year, there will be tremendous pressure on them to make something between now and year-end. Midterm elections are a tradable event, so look for more volatility into early November. And since traders seek out volatility one would expect markets like energy, Tech stocks and VIX-related products/options to see larger price swings.

#3. All this adds up to continued US equity market volatility, as we highlighted in yesterday’s Data section. We were a little taken aback by the thought that the S&P 500 has a +30% chance of making a fresh 2018 low. But then we realized that’s why hedge funds pay Lou for her/his advice. Considering the outlier event and planning for it… That’s what risk management is all about.