Crazy days we're living in. As I write this, things are terrible. Not just terrible … so terrible that stock exchanges faced the possibility of calling in the financial riot police -- circuit-breaker rules -- to shut down markets if things get too rowdy.
That hasn't happened quite yet, and to be honest, it's anyone's guess what will happen before the day's out. 1,000-point drop? 1,000-point gain? Odds of each happening seem just as likely these days. The VIX "volatility index" stopped just short of 90 this morning -- by far an all-time high, and an absolutely unthinkable reading until recently.
Well, yeah, the economy's a mess
But, come on, I'll be impressed if someone can give a rational explanation for why the intrinsic value of Procter & Gamble (NYSE:PG) was worth 6% less this morning than it was yesterday. Or why the long-term value of Coca-Cola (NYSE:KO) suddenly dropped 7% this week over last. They couldn't do it. There's little, if any, explanation for the volatility.
Something else is lurking around markets right now, shaking things apart at a furious pace. But what? Here's one reason that sticks out in my mind.
Hedge funds
Coming off one of their worst months ever, hedge funds -- which control (well, controlled) trillions of dollars of capital -- are facing an onslaught of redemptions from investors who either need their money back to cover their own losses, or are scared out of their minds now that their once-stable returns have turned against them.
Either way, when clients yank money out, legions of former master-of-the-universe managers start selling untold amounts of money indiscriminately and, on days like today, all at the same time.
On top of that, most hedge funds have what are called "high-water marks," meaning the fund manager has to make up losses before they can charge performance fees in the future.
The average hedge fund is down 17.6% year to date, meaning most funds have to score considerable gains from today's levels before a manager could start charging performance fees again. Connect the dots, and you get a situation where even hedge funds that aren't facing client redemptions have an incentive to shut down. When they shut down, they sell. Everything. Quickly. And the results can equal downright hysteria.
How bad can it get?
One of the most outspoken voices of how apocalyptic things might get is NYU professor Nouriel Roubini. He saw most of this coming years ago, but no one took him too seriously until recently, when his predictions became true.
What's he saying now? Earlier this week, Roubini predicted, "There will be massive dumping of assets … hundreds of hedge funds are going to go bust." Gulp. He followed up by saying, "We're seeing the beginning of a run on a big chunk of the hedge funds … don't be surprised if policy makers need to close down markets for a week or two in coming days."
I hope he's wrong, but honestly, betting against Roubini has been a losing battle lately. The important thing to keep in mind is that, if that situation were to occur, it'd create what would undoubtedly be the buying opportunity of a lifetime.
If you're hell-bent on weathering this storm and holding your investments for years to come, you have little to worry about. If you stick to underleveraged, high-quality, cash-rich names such as Berkshire Hathaway (NYSE:BRK-B) or Microsoft (NASDAQ:MSFT), you'll almost certainly find yourself in a much better position five or ten years down the road.
Bubbles burst. Panics create opportunities. Patience pays.
Hang in there.
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