Thursday, March 8, 2007

The Chicken, The Egg and The Hedge Fund Flu

Watching markets very closely during the past few days, the tight relationship between the yen and global equities was unmistakable. The question is, does a rising yen push stocks lower or do lower stocks push the yen higher - and vice versa?

Well, does it really matter? Answering "what came first, the chicken or the egg?" is unimportant, if all you want is a chicken salad sandwich or an omelet - both chickens and eggs already exist. Likewise, the yen is undervalued and stocks are overvalued. The rise of momentum/trend following speculators like hedge funds has a lot to do with stretching otherwise unsustainable conditions past their fundamental boundaries, always in search for that extra little bit of marginal return. It is now estimated that hedge funds control approx. $1.5 trillion in invested capital.

Once the trend reverses, however, hedge funds will push just as hard in the other direction - this is their nature as momentum/trend followers. Since their size vs. the overall market has grown tremendously over the past five years, this change in course may not come as gradually as before and may again relentlessly extend much beyond fundamentals in the other direction.

To get back to the chicken/egg situation, hedge funds could end up being the "bird flu" of global financial markets, killing both chickens and eggs. Just as a mindless virus attacks due to its genetic programming, hedge funds' strong natural inclination to trend/momentum plays may wipe out the entire chicken coop.

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