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Welp, it happened again: Another hedge fund made some leveraged, concentrated, speculative moves that didn’t work out, and wound up getting hit with margin calls it couldn’t meet. That forced sales of about $20 billion in assets on Friday and saddled its prime brokers with billions of dollars in losses. Fears of forced selling were everywhere before markets opened Monday, with plenty of pundits warning of contagion and drawing comparisons with the demise of Long Term Capital Management (LTCM) in 1998. But the widely feared storm never really materialized. US markets finished down just -0.09% Monday—a placid day by virtually anybody’s measure.[i] Hopefully, this is the first step in folks realizing markets aren’t likely to prove fragile enough that one failing fund starts a cascade of forced selling.
The firm in question today is Archegos Capital Management, which is known in industry jargon as a family office—an investment shop that exists to manage family wealth. In this case, the wealth belongs to a former hedge fund tycoon who earned some notoriety a few years back, which you can read about on any financial news site you like. The firm, under his direction, had what most would probably consider excessive margin loans, using borrowed money to take huge positions in a handful of old-line media companies and large Chinese Tech firms.[ii] When those hit some speedbumps earlier this week, it forced margin calls, which Archegos lacked liquidity to meet. That triggered the aforementioned $20 billion in security sales, which drove the affected stocks even lower. That all happened Friday, which is why the masses anticipated a wave of forced sales on Monday.
We have no way of knowing how much forced selling actually happened Monday, as hedge fund trades are notoriously opaque. The likelihood any of that gets publicly reported is low, absent big banks having to report losses from relationships with additional “whales” like Archegos. One thing is clear, however: The stock market didn’t register some broad contagion. The S&P 500 fell at the outset but finished the day largely flat. European indexes were largely up on the day. The stocks fire-sold Friday didn’t suffer another bloodbath. A couple of investment banks were hit hard as they revealed their exposure to Archegos. But beyond this, markets moved on, even as the news world didn’t.
That doesn’t really surprise us. For one, while pundits have made much of the losses two of Archegos’ counterparties disclosed, those losses aren’t huge when you compare them to these firms’ abundant capital. Two, contagion from individual funds blowing up and tanking markets broadly is largely the Bigfoot of the financial world—often spotted, never seen. LTCM? When its derivatives trades blew up most feared massive fallout on a scale far exceeding the firm’s assets under management. The New York Fed organized a $3.6 billion bailout thereafter. But LTCM got bailed out because of contagion fears, not contagion evidence. Regulators, like the otherwise smart folks who ran LTCM, can err and overreact.
Similarly, hedge fund failures in 2007 didn’t start a chain reaction until late in the year, when illiquid held-to-maturity assets on banks’ balance sheets became subject to mark-to-market accounting. Funds blowing up the summer before that didn’t have the cascade effect. Even then, the problem wasn’t forced sales but the writedowns every bank would have to take every time a hedge fund sold an illiquid asset at fire sale prices. Regulators amended the rule to prevent this in early 2009, so it isn’t an issue now.
There was a major instance of forced selling impacting stocks a few years back. You might remember markets plunging in December 2018, nearing bear market territory (-20% from their prior high). Our research at the time indicated hedge funds’ forced sales were the culprit. But not because one firm’s problems infected the rest. Rather, after years of poor performance, a flood of funds closed all at once after determining it was cheaper to fold and start anew rather than take a continued revenue hit (our firm’s founder and Executive Chairman, Ken Fisher, detailed this in a column for USA Today at the time, which you can find here). As hedge funds dumped stocks indiscriminately, retail investors panicked, and everyone ran for the exit at once. But the selloff ended as suddenly as it began, and we think there is a simple reason: Forced sales of that nature represent a change in hedge funds’ business conditions, not broader market fundamentals. Many, many investors were all too happy to buy companies at a discount, and it didn’t take long to bid prices back up. That is just how markets work.
In addition to being a handy lesson, this saga suggests to us sentiment hasn’t flipped into euphoria yet—pockets of skepticism remain, just as they did in 1998. Fears surrounding LTCM were a good sign the 1990s’ bull market hadn’t reached euphoric heights. That turned out to be true, as the bull market roared higher until late-March 2000. But it was one of the final bricks in that bull market’s wall of worry, which makes the evolution of sentiment from here worth watching with a critical eye. If markets’ resilience to the Archegos speedbump helps investors globally get more confident, then we could be on the road to euphoria sometime in the not-so-distant future. That doesn’t mean a peak is nigh—we are bullish!—but it does merit a watchful eye for expectations eventually running far ahead of reality.
[i] Source: FactSet, as of 3/29/2021. S&P 500 price return, 3/29/2021.
[ii] We are intentionally oversimplifying this in order to avoid a long tangent about swaps and options contracts. Suffice it to say there were multiple layers of leverage from multiple counter parties who, according to several reports, didn’t know the full extent of their client’s borrowing.
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