A Deflated Balloon Can't Bounce

Well, we had our bear market rally early this morning, all 15 minutes of it. From there on, the Dow Jones plunged yet another 508 points to reach a five year low of 9,447.

Things are way oversold and according to the Financial Ninja, we are due for an oversold bounce. Moreover, I agree with the Ninja that Jim Cramer's dire warning to sell stocks almost guarantees a bottom.

One little hitch to this oversold bounce theory. As one astute money manager commented to me tonight: "a deflated balloon can't bounce".

And the balloon is deflating fast as virulent deleveraging continues to wreak havoc on all asset classes.

Virulent deleveraging is hitting hedge funds particularly hard:

Hedge funds' losses ballooned last month when the average portfolio tumbled 4.68 percent, marking the industry's worst monthly performance, according to new data released on Tuesday.

The average hedge fund has now lost 9.41 percent this year, data released by Chicago-based performance tracking group Hedge Fund Research showed.

Hedge fund managers and investors first began talking about the industry's losses at the end of September and Tuesday's numbers confirmed what many people already knew.

While the industry's losses are less than the average stock mutual fund's drop, they are shocking to investors who entrusted millions to managers in return for promises to make money in all markets.

The industry's year-to-date losses are now more than double the 4.83 percent drop seen in the first eight months of the year.

Managers and investors blamed September's violent stock market moves plus regulators' ban on selling stocks short and the collapse of Lehman Brothers for the accelerated losses.

Some of the industry's biggest names numbered among the industry's losers -- Kenneth Griffin's Citadel Investment Group, Dan Loeb, an activist investor, and Lee Ainslie, who once worked for industry legend Julian Robertson.

The biggest losers were hedge funds that focused on energy and basic materials. According to HFR they lost 13.21 percent in September, putting them down 20.84 percent for the year.

It is scary to see Chicago's Citadel Group, the giant multi-strategy hedge fund run by Ken Griffin so successfully for nearly 20 years, is now leaking money:

As of Sept. 30, its two main investment funds were down 20 percent this year, according to Citadel investors. Most of the losses came in the last few weeks, when the markets swooned. Two other smaller Citadel funds are still well in the black.

While many hedge fund high-fliers are falling back to earth this year, few have soared quite as high as Mr. Griffin. With an estimated net worth of $3 billion in 2007, he ranked as the 117th richest American, according to Forbes. (Mr. Griffin paid $60 million for Cezanne’s “Curtain, Jug and Fruit Bowl” in 1999. Four years later, he was married in the garden at Versailles.)

But with the entire hedge fund industry on edge, even Mr. Griffin is considering what once would have been unthinkable: reducing some of the lavish fees that investors pay Citadel to tend their fortunes.

It just goes to show you that even the best and brightest managers underestimated the global systemic nature of this financial crisis and are now struggling to survive in what is increasingly looking like a slow motion smash-up (akin to Chinese water torture).

And it isn't just hedge funds that are suffering from virulent deleveraging. The global credit crisis and market meltdown appear to be taking a heavy toll on the world's private-equity markets:

Indeed, a mere $82.3 billion was raised by 117 funds in the third quarter according to research by Preqin, an alternative-asset information provider. That was the lowest amount raised since the first quarter of 2005, when 159 funds scooped up just $64.8 billion.

So far this year, a little over $400 billion has been raised by PE funds, according to the Preqin report, which defines private equity as any alternative investment class, including buyouts, venture-capital and real estate, but not hedge funds. Last year, PE funds raised more than $628 billion, up about 15 percent from 2006.

Preqin points out that, based on a 12-month rolling period, the peak of the market can be traced back to the first quarter of 2008. "Private equity fundraising is set to enter its most challenging era of all time," Tim Friedman, a company spokesman, said in a press release. "The very biggest firms may be able to gather commitments from previous investors, but many of the less experienced mid-sized and smaller funds that constitute a higher risk in the eyes of investors will find conditions to be extremely tough."

It is especially tough out there for pension funds. As most of the world's major stock market indexes are down 30% to 40%, global pension funds will face huge losses in 2008.

Importantly, diversification into alternative assets will not help cushion the losses and in most cases, they will exacerbate the losses.

Today, the Congressional Budget Office said that Americans' retirement plans have lost as much as $2 trillion in the past 15 months:

The upheaval that has engulfed the financial industry and sent the stock market plummeting is devastating workers' savings, forcing people to hold off on major purchases and consider delaying their retirement, said Peter Orszag, the head of the Congressional Budget Office.

As Congress investigates the causes and effects of the financial meltdown, the House Education and Labor Committee has heard from retirement savings and budget analysts on how the housing, credit and other financial troubles have battered pensions and other retirement funds, which are among the most common forms of savings in the United States.

"Unlike Wall Street executives, America's families don't have a golden parachute to fall back on," said Rep. George Miller, D-Calif., the panel chairman. "It's clear that their retirement security may be one of the greatest casualties of this financial crisis."

I can guarantee you that retirement plans across the globe will suffer carnage as assets prices deflate and many defined benefit plans will have to face tough choices like cutting benefits, stop adjusting for cost of living, or increase contributions.

Moreover, as the economy slows, deflation could loom:

The confluence of trends has some economists worried that the country could be headed for a debilitating cycle of deflation: a period in which weak consumer demand, falling prices and tight credit ignite a downward spiral of still weaker demand and still lower prices. Under this scenario, as some businesses are strangled, joblessness increases, feeding the cycle.

"It was just a few months ago that everyone was obsessed with inflation. Now it's deflation," said Bill Gross, co-chief investment officer at Pimco, an investment management company. "I think it's a possibility."

The value of a wide range of assets, from commercial real estate to stocks and bonds, has declined over the past year. Concerns about falling asset prices are compounded by a banking and credit crisis that has quickly become a global contagion.

...

Some economists note that a period of price adjustments does not necessarily signal the start of a deflationary spiral.

"Deflation is not the problem we should be worrying about," said Adam Lerrick, an economist at Carnegie Mellon University. "A drop in the level of prices for some goods must be distinguished from a continuous fall of prices. Oil is down to $90 from $140, but does anyone expect it will be $55 a year from now and $35 in 2010?"

Analysts said that a few months of price declines should not be a problem for the economy.

But if prices continue to fall across the board for a prolonged period, the declines will weigh heavily on businesses and consumers, particularly those juggling a lot of debt, which must be paid back even as money is harder to come by.

"For a few quarters, I say bring it on, but not for too much longer," Gross said of deflation. "Capitalism depends on mild inflation. Unless we get it, the dynamics of capitalism sort of move in reverse."

Japan is the cautionary tale that economists point to when it comes to deflation. Beginning in the 1990s, the nation spent a decade wrestling with flat growth as consumer prices declined about 1 percent a year. The result was not only painfully slow growth, but also rising joblessness -- a problem that economists said was fed by the slow response by Japanese central bankers to a stock and real estate crash that sparked the downward spiral.

In the United States, policymakers have been much quicker to respond to deflationary threats. Five years ago, as inflation approached 1 percent, spawning deflation concerns, Alan Greenspan, then the Federal Reserve chairman, cut the Fed's benchmark lending rate to 1 percent and the threat was never realized. It is an outcome that gives assurance to some economists.

"As long as governments print money and run deficits, you cannot have deflation," Lerrick said.

We shall see if the monetary printing presses will stave off global deflation. I remain unconvinced that monetary spigots will cure the underlying structural debt problems that are clogging up the global credit system.

For now, virulent deleveraging continues to wreak havoc across all asset classes and all sectors. Some see this a long-term buying opportunity.

I would tend to agree, especially in the sectors that will figure prominently in the future of global energy needs. One such sector that I keep referring to is the solar sector which has gotten crushed in the last selloff:

...many industry analysts say that the recent tax extension for alternative energy companies contained in the $700 billion U.S. bailout, paired with the shock of record crude prices this summer, bode well for the industry.

"Long-term solar projects need debt and equity so with the cost of money going up, there is going to be a reduced return on projects," said Robert W. Stone, an analyst with Cowen and Co.

"But with the global economy being what it is, it's still going to look like a pretty good investment comparatively, even if these turn into single-digit returns compared with what might have been a double-digit return in the past."

At these levels, I am buying up solar companies for the long-run. I believe in the future of the solar sector and the fundamentals of these companies are incredibly strong (watch earnings later this month validate my claim. Also, read this Forbes article, Sunny Day For Solar Start-Up).

But the reality is that you have to be very patient if you are long any stocks because in this environment, animal spirits rule and even good companies are being decimated as investors indiscriminately sell into any rally.

***Morning update:

The Fed, ECB, Bank of England, Bank of Canada and Sweden's Riksbank each cut their benchmark rates by half a percentage point. The Bank of Japan, which didn't participate in the move, said it supported the action. Switzerland also took part. Separately, China's central bank lowered its key one-year lending rate by 0.27 percentage point.

From Bloomberg:

``The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability,'' according to a joint statement by the central banks. ``Some easing of global monetary conditions is therefore warranted.''

The Fed's decision brought its benchmark rate to 1.5 percent. The ECB's main rate is now 3.75 percent; Canada's fell to 2.5 percent; the U.K.'s rate dropped to 4.5 percent; and Sweden's rate declined to 4.25 percent. China cut interest rates for the second time in three weeks, reducing the main rate to 6.93 percent.

The Fed's Open Market Committee, which voted unanimously for the move, said in its statement that ``incoming economic data suggest that the pace of economic activity has slowed markedly in recent months. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending.''

The Fed also cut its rate on direct loans to banks, the so- called discount rate, by a half point to 1.75 percent.