Tuesday, October 7, 2008

Totally OT: Aggressive Short Selling of S&P Futures

(This is my second totally off topic economic post.)

I've been wondering if the current market collapse is being driven by hedge funds aggressive short selling of S&P Futures in order to hedge their long positions on individual stocks. I was glad to see that someone else has been wondering the same thing:
Beginning last Monday, I began to see a number of big hedge funds in the S&P 500 futures pit, boldly selling futures to hedge their core long holdings. As the market dropped precipitously on both Friday afternoon and Monday afternoon, they got ever more aggressive -- according to my sources, more aggressive today than at almost any point in a decade or more.

If my observation is correct -- and we will get some sense of this on Friday afternoon when the size of the professionally hedged S&P futures positions are released; our thesis will be proven correct if there is a large increase in open interest -- it will be proof positive that those hedge funds are now shorting the hell out of S&P futures in order to hedge their cratering longs. Indeed, some of those hedge funds might now even be overhedged and short S&P futures, as it has been working.

This strategy is a classic tactic one sees at panic/capitulation lows as hedge-hoggers sell short what they can sell easily -- the S&P futures market is deep and liquid -- while they retain what they can't sell easily (i.e., large blocks of individual equities). I have always been concerned about where the marginal buyer would come from, especially with the SEC ban, and, again, if I am correct, the momentum of a rising market into the all-important year-end could now cause a reverse panic to the upside as hedge fund managers that have overhedged their portfolio with futures buy them back and cover their positions just as fast as they sold them short.

Indeed, it is quite possible that those managers could lose both ways -- on the upside on their short futures positions (which some have overhedged because it's been working!) and as their core holdings fail to perform in line with an advancing market.

That's what I see happening recently in the S&P futures pit, and even if I am only half correct, those hedge-hoggers could be on a sinking ship without a life preserver as the stock market might have bottomed under the weight and intensity of their aggressive short selling of S&P futures.

In summary, investors and traders might now be looking for the answer to the market's recent drubbing in all the wrong places. The fundamental news is bad, but this is known and is arguably being cured by public and private sector initiatives. Rather, it could be that the recent behavior of hedge funds -- namely, their imperious and aggressive shorting of S&P futures -- is even worse than the fundamentals and might be a root cause for the precipitous market drop over the past 10 days.

As with Kass, I'm not denying the weak fundamentals. I am just wondering if something else is going on as well.

From Doug Kass on TheStreet.com

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