INVESTING: Domino effect worsened woes in subprime market

Subprime. Liquidity injection. Volatility spikes. The equity markets have woken up from a long slumber, and the fallout has both short- and longterm consequences.

Everyone loves a good mystery, which is why recent stock market events have been attracting so much attention. However, I did my best impression of Sherlock Holmes and believe I have solved the case.

Here is how it went down. Two large hedge funds run by Bear Stearns invested heavily in the subprime mortgage market. Delinquencies went up by such a degree in June and July that these funds started losing an incredible amount of money. As news of the funds’ problems hit the markets, investors dumped shares of home builders and mortgage firms.

Then, on top of that, super-sized quantitative hedge funds sold those same stocks short, hoping they would fall even further. All this selling pushed these stocks down so much that bargain hunters began nibbling at the stocks. The nibbling was all that was needed to create a short squeeze, which hammered the quantitative funds.

The institutions that lent money to the quantitative funds saw losses increasing and demanded some of their money back. To get the demanded cash, the funds had to sell their long positions in stocks like Boeing and IBM, which led to the drubbing in the Dow Jones industrial average. Easy, right?

It is not surprising to me that a few funds were wiped out by the subprime mess (the Bear Stearns hedge funds declared bankruptcy last week). It is surprising, though, that people who should know better are washing up on the rocks.

These giant quantitative funds are run by firms like Goldman Sachs and JP Morgan. The funds attempt to pick securities based on mathematical models and scores. The problem lies not with the math but with the leverage. These firms play with eight to 10 times the amount of money investors put in the funds. Obviously, that magnifies gains, but it blows up the losses.

The two largest hedge funds run by Goldman have lost 24 percent and 28 percent so far in August. A JP Morgan fund has lost 16 percent so far this year.

Volatility is at five-year highs. Central banks all over the world have been injecting liquidity in the markets by nearrecord amounts. The S&P 500 now has experienced its largest decline since the bull market began in early 2003. This probably means more to go on the downside over the short term. I still think we finally will experience a 10-percent correction, something we haven’t seen in more than four years. I also think prices will rebound at least one more time before this thing really ends. I expect new highs in most of the major averages.

As for the longer term, if these investment banks are experiencing this kind of pain in what is really not that turbulent of times, just wait a year. As I mentioned a few weeks ago, the seeds of the next bear market have been planted. It could take a while for the seeds to get going, but when they do, watch out!