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Friday October 21, 2005 - 11:26:55 GMT
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Volatility and Liquidity

Key News
•Key reports due today (WSJ):
No major economic indicators are scheduled for today.

“Don’t fight the Fed.”

Marty Zweig

FX Trading
A wise friend, who is a bit concerned about the market, forwarded us Jeremy Grantham’s quarterly letter. Mr. Grantham is a major player on the institutional scene, with approximately $125 billion under management, give or take $5 to $10 billion here or there. Mr. Grantham also has a reputation for making prescient market calls throughout his long and extremely successful career as a money manager—and providing real reasons for said calls. In a piece entitled, “The Day of Reckoning or Ready or Not, Here Comes the Risk Premium,” Mr. Grantham defines how our world of seeming low volatility and high liquidity can change very quickly [our emphasis]:

“From time to time, the market has had liquidity crises in which the need to sell illiquid positions has caused extreme price weakness, which in turn has precipitated more selling. We now exist in a world of a 1 trillion dollar hedge fund industry (without counting their huge leverage) that has risen to at least 25% or 30% of total daily stock trading. Hedge funds are fairly reliably claimed to be longer less liquid holdings than they are short, since they attempt to benefit from the risk premium. The Long Term Capital crisis was an example of what can happen as a wave of selling illiquid issues snowballs.

“VAR [value at risk] runs the risk that illiquidity and volatility can interact. Any major liquidity crisis will show up as a spike in market volatility, causing VAR portfolios to lower their aggregate risk by selling into weakness, creating a dangerous self-reinforcing cycle of a kind that hedge funds are paid to anticipate and exploit. As if this were not enough, rising interest rates are also involved. Low rates justify more leverage, just as low volatility does. As rates rise, the justifiable level of leverage contracts, and selling of leveraged hedge fund portfolios begins. An equal reduction of long and short portfolios, if hedge funds are long illiquid issues, will then result in less liquid issues underperforming and may start the turtles running down the beach.

“High leverage and rising rates, plus rising volatility and VAR, combined with a liquidity premium and asymmetrically illiquid hedge fund portfolios is a heady brew, and a dangerous one. The usual brake on a market decline is value: as stocks and assets decline, they become cheaper and hence more attractive. In our new world that seemingly ignores value as a risk component, falling assets are more likely to merely become more volatile and hence be seen as riskier and less attractive.”

Cahrt: S&P 500 Index Weekly

We noticed that Jim Rogers, ex-partner of Mr. Soros and commodity crowd favorite (one of ours too, truth be told, though his love of TV cameras make us a bit nervous at times) has 63% of the Rogers commodity fund stuck inside Refco—that he can’t seem to get at, according to a story from Bloomberg yesterday.

One has to believe there might be other fund types, many of the so-called “hedge” variety (hedge is misnomer when you consider most of these funds are vanilla one-way bet oriented), stuck in a similar situation as Mr. Rogers due to their unfortunate association with Refco. And maybe this would be a catalyst for the interaction between liquidity and volatility that Mr. Grantham so deftly describes as a danger.

Could this have something to do with the huge reversal in stocks yesterday—one day after what was billed an “earnings” rally on Wednesday by the market cheerleaders?

We are going with the advice of our wise friend who sent us Mr. Grantham’s piece. He said in an email to us yesterday:

“Everything down but cash! What to own now? Certainly not risky stuff as it has been destroyed.”

Cash gives us time to think and a place to hide. Not a bad place to be in this market.

Jack Crooks
Black Swan Capital


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