Monday, August 4, 2008

Are Hedge Funds Ruining the Market?

Hedge funds are a fairly new phenomenon. If you're unfamiliar, they're basically large pools of money invested in nearly any asset class with little structure and little regulation. They're only offered to "accredited investors" (minimum of US $1 Million). For the full rundown, click here.

My point is take a look at recent market action. You've got rotation in and out of various sectors like crazy. Trends can change and reverse course within hours. This phenomenon is not only difficult to stomach for long term investors, but it creates asset bubbles. The buildup of excess leverage and vast liquidity has formed under a hedge-fund dominated market (the past 10+ years). As the money swings from one asset class to another, these bubbles get inflated and deflated, often taking out entire companies (and many investors) when they deflate. This causes major disruptions in the market. The technology bubble, the real estate bubble, and the commodity bubble all have inflated and deflated (whether the commodity bubble has deflated is still up for debate). These events have major ramifications. And most of them are negative for average consumers who many times never took part in profiting from the inflation of the bubble.

Trader Mark has spoken at great lengths about this. It is almost impossible to invest with a medium to long time horizon now. You have to "drink the Kool-Aid" and ride the trend that the funds choose. Earnings don't matter. Positive catalysts don't matter. Strong outlooks don't matter. If the funds have decided the trend is over, then that stock is going down. And hard.

Take a look at XTO Energy (XTO). This oil and gas stock, with one of the largest amount of gas reserves, and is fundamentally very strong, has completely broken down. On June 23, it closed at 73.40. Today, it closed at 43.54. Fundamental analysts have no explanation. The company posted strong earnings last week and said their production output will increase larger than expected, as well as a strong EPS growth. Technical analysts have no explanation. The stock has crashed through its 50 and 200 day moving averages with no sign of "support." Its like sector ration on steroids. Doesn't it seem like everything is juiced up these days?

Given all this, what is an individual investor to do? Stocks may as well be just symbols of random letters, not an underlying company. For those of us who listen to Buffett's success stories, and how he chooses a stock, it is a bit hard to take. I wonder what he thinks about this? What does anyone else thing about it? Are hedge funds ruining the stock market?

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