Trust and Volatility

Watching the financial markets with a more attentive eye for these past months has given me some insights into what I like to call ‘market psychology’. I’ve realized that lately, stock price changes have had less to do with facts, figures, and metrics, but have been influenced more by perceptions, expectations, and other less tangible aspects created by the minds of institutional investors.

Markets have been experiencing unprecedented volatility over the past weeks. It’s become common for good, solid companies to take a 5-10% loss in a day for no apparent reason, then bounce back up the following day almost as much. Retail investors are losing trust in stocks and the way they are traded. This mistrust is understandable when you see these big swings that are based on nothing logical. Jim Cramer describes it as “a broken casino where stocks move in 3, 4, or 5 point increments over [...] whiffs, rumors”. There are several other reasons why the markets are so out-of-whack, including a transitional US government; rising unemployment causing income insecurities; and uncertainty on just about everything from input costs to waste disposal. But perhaps there is a sinister role being played behind the scenes in all of this.

Hedge funds have to be making money, regardless of whether the market is going up or down. Long or short, they need to generate cash. That’s why they exist. They also have the power to borrow money to make investments on margin (where they put up 1/2 or 1/3 or the cash and borrow the rest). When markets were up, they were profiting and pushing stocks even higher. Now that markets are down, one fund will be forced to sell at bad prices, while another will vulture the stock by shorting, and buying it back when the first company is done dumping it. This theory assumes two things: 1) that hedge funds are in cahoots; and 2) that they are greedy enough to sacrifice long-term retail investor trust in order to make a quick buck. You make your own call, but I’d recommend watch Jim Cramer’s 13-minute rant on the subject.

If I’m right, then major structural changes will need to be made before these markets can earn back the trust of mainstreet investors. Until a reasonable degree of consistency is restored, it is hard to recommend any stock based solely on good fundamentals. Anyone got the number to a Wall Street hedge fund manager for me??