It was May of 2008 and I lost it. At the time, I was a portfolio manager at the Galleon Group which was an $8Billion long-short equities hedge fund run by the now infamous Raj Rajaratnam.  I was net-short the market, so betting that stocks would go down.  My short positions were concentrated in housing related stocks and discretionary retail.  Though the collapse of Lehman Brothers and equities broadly was only months away, in May, I was getting my face ripped off.  Essentially, I was short a lot of the same stocks as other traders and we were all trying to reduce exposure and manage risk at the same time pushing our respective positions higher and exacerbating our losses. We were well into the start of the Great Financial Crisis bear market, but in May, due to some piece of better economic data, the counter-trend rally was violent and I wasn’t handling it particularly well.  I was shocked to learn how high and how far the keys from the periphery of a Bloomberg keyboard could fly when a well-placed hammer fist comes slamming down on the center.

The feeling of losing money in a bear market is acute pain.  It is a feeling of fear and humiliation.  Remember, with a short position, your downside is infinite.  Consider a situation like GME in early 2021 when within a month, the careers and personal wealth of far better traders than me were destroyed. Keynes told us that “Markets can stay irrational longer than you can remain solvent”, and that is exactly what makes active trading so hard. The pain of being on the wrong side of a short squeeze is one that is shared by all professional traders.  Some just have less ego, better process, more discipline, and shorter memories. 

Trading long-short and managing risk when you have a high conviction view is extremely difficult when the squeezes invariably come.  In the bear market that stretched from 2000 to 2002, there were eleven bear market rallies of 10% of more before the final real bottom came and the new bull market began.  When those rallies occur, none of us have a crystal ball and none of us actually know if it is a head-fake or the real McCoy.  Each one of these rallies can eviscerate the trader who may prove to be right longer-term but wasn’t able to manage the shakeouts along the way.  In fact, I spent more than a decade in hedge funds and prop trading desks.  Of the well over one hundred traders with whom I worked and got to know in those years, I can think of three that I believe can generate real uncorrelated alpha over an extended period of time. 

The recession which may or may not arrive has been called the most anticipated recession in US history.  Bloomberg ran a headline in October that read, “Forecast for US recession Within Year Hits 100% in Blow to Biden”.  But all of a sudden, the narrative of a soft landing with the Fed cutting rates (immaculate disinflation) is now winning the day.  The people running long-short money have not changed their fundamental view.  They still see the money supply data, Housing and the leading economic indicators pointing in the same direction, which is toward a recession.  This consensus is not going to look at the Fed raising interest rates by 450 basis points and decide that maybe this time is totally different and there will be no discernible impact on consumer and business demand.  However, this bearish consensus still has to manage risk.  In many cases, the risk management policies of traders is pre-determined leaving them no option but to buy back short positions twenty and thirty percent higher from where the positions were initiated.  In other words, many of the professional investors buying Tesla and Carvana today are the people with the most negative views of those company’s fundamentals.

My point is that this market rally is driven more by fear of insolvency than fear of being fundamentally wrong long term. 

I don’t know if the current rally is justified or not.  While I suspect it isn’t, as Powell said this week, “Certainty is just not appropriate here”.  I will say this, historically when unemployment gets to these extremely tight levels, monetary policy is going to work against you.  At 3.4% unemployment, you are still fighting the Fed.  Ultimately, the lesson of the current market action should be to embrace humility.  My experience with short squeezes is that they tend to last longer than the best forecasters expect.  Ultimately though, to paraphrase Ben Graham, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”  The transition from virtually free money to normalization of credit costs and tighter availability of credit will carry a lot of weight.

 
For more from Tim, follow his podcast The Weekly Bull and Bear wherever you listen to your podcast or read his weekly blog posts here.

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