Rallies Show Even Brightest Can Come Out on Short End

Some of the brightest money managers in the world have been on the wrong side of stocks, bonds and the dollar this year. Which is one major reason the rallies in those markets have been so explosive.

Wall Street’s main preoccupation lately has been one of catch-up, as many big investors scramble to get on board the runaway stock and bond bull markets--or as they rush to cover “short” positions, ill-fated bets that the markets would go down instead of up.

It’s important for individual, buy-and-hold type investors to understand what fuels such short-term market frenzies, if only to avoid getting suckered into transactions that can disrupt a disciplined long-term investment program.

The dollar has become the latest challenge for Wall Street pros. The buck suddenly soared last week from its depressed levels against the Japanese yen and German mark, and by Friday it had leaped 5.3% against the mark and 3.3% against the yen compared to a week earlier.

Ostensibly, some currency traders were taking a more positive view of the dollar’s long-term prospects in the wake of last week’s House and Senate budget committee votes approving drastic federal spending-cut blueprints through 2002.

Whatever the reason for the dollar’s turn, once the trend changed, a host of people had to cover short bets or face potentially unlimited losses.

In a short sale, a trader borrows a security (or currency) and immediately sells it on the open market. Assuming the market price then declines, the trader can eventually repurchase the security at a lower price, return the security to the lender and pocket the difference between the original sale price and the repurchase price.

When a short bet works, it can be extremely lucrative. But if the bet is wrong--and the market soars instead of falls--a short seller is in the red until he finally decides to repurchase the surging security and close out the trade.

It’s impossible to measure exactly how many traders were short the dollar going into last week, because such trades can be made worldwide and in all sorts of convoluted transactions.

But bearishness over the dollar had reached extraordinary levels just a few weeks ago. Pasadena-based Market Vane Corp.’s weekly Bullish Consensus newsletter, which surveys trader views on stocks, bonds, currencies and commodities, recently showed just 11% of traders were bullish on the buck.

That undoubtedly translated into significant short positions, the most recently placed of which instantly became losing bets with last week’s dollar rally. Hence, some short sellers bought dollars in a panic last week to exit their trades, and what might have been a minor dollar rally quickly fed on itself.

For the short bears, that’s the ultimate insult: Forced to buy, they help drive the very price gains they had bet against.

Now the abrupt turnaround of the dollar “certainly suggests some people have changed their minds about structural (trading) positions” against the greenback, said Dennis Pettit, foreign exchange manager at the Long Term Credit Bank of Japan in New York.

Translation: The dollar may have Big Mo (momentum) on its side for a while, as more bears call it quits.

Short sellers have also been murdered in bond and stock markets this year, as interest rates have fallen far more than expected and as stock prices have rocketed.

Late last December, it was a reasonable bet that the U.S. economy would continue to grow at a fast clip in the first half of this year, leading to higher interest rates and potentially to lower share prices.

But traders who smugly shorted those markets or otherwise hedged themselves have looked like chumps almost continually since Jan. 1, as bonds and stocks have rallied virtually nonstop.

When bond bears finally began panic short-covering during the first week of May, bond yields went into a free fall. The yield on five-year Treasury notes, which was 7.82% at the start of the year, dove from 6.88% on May 1 to 6.35% by last Tuesday, though by the end of last week the yield was back to 6.45% as inflation jitters revived.

In the stock market, the bull move that many bears earlier this year decried as pathetically narrow--it was merely a rally in a few blue-chip shares, the doubters claimed--has swept the broad market higher with barely a pause.

The Dow Jones industrial average, at a record 4,430.56 on Friday, is up a stunning 15.6% so far this year. And even the laggard broader indexes are up respectably. The Russell 2,000 index of smaller stocks has gained 7.8% since Jan. 1, a rise that may not be a barn burner but nonetheless represents a tidy profit.

Unless, of course, you are short stocks, in which case the bulls’ gain is your loss.

William Lyons, editor of the Atlanta-based Short on Value newsletter, which ferrets out stocks believed to be ripe for a plunge, says his model portfolio of recommended short sales has lost 7% so far this year.

Although Lyons says his portfolio gained 14% last year as many stocks stumbled, he concedes that bearishness in general has been a wrong-way bet this year. “When you have a quarter like the first quarter in the market, you don’t want to be short at all,” Lyons said. “But who can predict that?”

In fact, one group of market pros is paid handsome fees to time just such market turns correctly: managers of hedge funds, those celebrated investment pools for wealthy individuals and institutional investors.

Unfortunately, the average hedge fund is having a lousy year, and a big part of the problem has been hedge managers’ short sales--either straight bets on falling stock, bond or currency prices, or short positions used to offset long (i.e., bullish) bets on markets.

In particular, the so-called macro hedge funds--those globe-hopping, opportunistic investors who try to time bull and bear moves in stocks, bonds and currencies worldwide--are having a miserable run, says George P. Van, whose Van Hedge Fund Advisors in Nashville, Tenn., tracks hedge fund results for 1,250 such funds investing $80 billion.

“The macro traders just haven’t been able to get it right” since the end of 1993, Van said.

Last year, the average macro hedge fund suffered a loss of 15.9%, Van said. And in the first quarter of this year, the red ink flowed again, with the average macro fund down 5%.

Meanwhile, hedge funds that focus specifically on short selling have followed last year’s 13.7% average portfolio return with a mere 0.1% gain this year, which may still qualify as a minor miracle given stocks’ and bonds’ surge.

Nonetheless, the macro and short-selling funds’ dismal results so far this year have helped drag down average hedge fund returns.

Van calculates that the first-quarter average gain for U.S. funds was 3.7%, compared to 9.7% for investors who simply bought and held the Standard & Poor’s 500 index of blue-chip stocks.

The first quarter should be viewed in context, Van notes: In the five years ended Dec. 31, the compound annual return for the average U.S. hedge fund was 15.3%, versus just 8.7% for the S&P.; So hedge fund managers by and large appear to be earning their keep so far in the 1990s.

Even so, Van says that market timing has become a much tougher game over the past 15 months even for the hedge fund geniuses who ought to do it best.

What has changed? Van believes that hedge funds and other short-term traders have in part become victims of their own success: So much money is trying to play the opportunist game today, in contrast with just five years ago, that market players may in a sense be tripping over one another, their herd movements skewing both bull and bear market cycles.

For long-term, buy-and-hold investors, the market “noise” generated by the traders can be nerve-racking but is probably best ignored. The short-covering going on this year is, in one sense, even reassuring: Just when some high-rolling group of investors or traders think it’s got the game all figured out, the market cruelly proves it wrong.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Tough Row for Hedge Funds

Betting against U.S. stocks and bonds this year--and, more recently, betting against the dollar--has been a losing proposition, which has hurt returns of high-rolling U.S. hedge funds that often take such “short” positions in anticipation of market declines. Annual returns since 1990 and first-quarter results for U.S. hedge fund average, the Standard & Poor’s 500-stock index and hedge funds that focus mainly on short selling.

1995 (first quarter)

Hedge fund average: 3.7%

S&P; 500: 9.7%

Short sellers: 0/1%

Source: Van Hedge Fund Advisors Inc