Cramer: Thwart the Hedgies


Editor's note: Jim Cramer will present his 2009 stock outlook for the first time at Investment Conference on Saturday, Oct. 25. Limited seating. Act now.

Will the U.S. government take the tough action that it needs to, giving $25 billion to Ken Griffin at Citadel to stop selling? Can't we just find out who the other hurting hedge funds are and given them each $25 billion and tell them to go home?

When I read that Citadel is down 30% on one of its funds -- probably has a dozen of them, for all I know -- I get chilled. When you are down that much and you run almost $20 billion, you are going to do a ton of damage exiting and hedging and scrambling, kind of exactly what Doug Kass said would happen when hedge funds go wild. For all I know, the erratic trading from Monday, the huge upswing, was from some strategy gone bad by a guy like Griffin who was trying to get some protection from a market decline while he exited and then got caught and had to cover.

Remember, no serious portfolio manager goes in and buys Exxon up 10 and sells Exxon down 10. No one who was trained as a professional -- no, not even a rank amateur -- would ever be that stupid. It just doesn't work like that.

But if you are running billions and you put on a short for a couple of billion dollars and your longs aren't running, you will be squeezed and the instruments you are using have so much heft and can so overwhelm the market that when you come in and say, "Sell those puts," you move the market incredibly.

I never thought it would happen again like in 1987, but then there was a firm, Leland O'Brien, that was guaranteeing performance using "dynamic hedging" that was supposed to be able to lock in gains for funds. The stuff didn't work because the market got overwhelmed and it went down so fast that the hedges didn't work.

The market right now is being overwhelmed by hedge funds using instruments that are way too powerful for the market when used in the size they are being employed. That's how you get big stocks torn asunder like this.

Like everything else that seems to go wrong in this era, we can't stop this madness.

You see when the hedge funds lever up as they do, when a $17 billion fund becomes a $170 billion fund, it can overwhelm the whole market. If two or three have the same strategy -- which they often do -- of shorting the market because their longs keep going down, if something good happens -- the bank bailout plan -- then a rally becomes a monstrous event to the upside. Perhaps the market should have gone up a percent or two; instead it goes up 10. Same thing on the downside: Perhaps the market should be down 2% on a bad forecast from a couple of companies. Instead because of the magnification factor, it goes down 10. When you add in the liquidations, it gets exacerbated even more.

In other words, it is possible, given the power and size of these funds, that we could have 5% to 10% swings until we get a handle on the leverage or make funds put down more money when they buy or sell these instruments.

Of course that won't happen. It is like credit default swaps. The government either doesn't understand the power these hedge funds have to move the market or it doesn't want to know, and the exchanges have little interest in stopping it because volatility is good business.

In the 1980s, lots of companies decided to initiate buybacks to protect their stocks from this volatility, and the collars were put in to cool the market down.

The collars, which became irrelevant as we got higher in points (as they were done by points and not by percentages) might help again. We need to be able to find sellers and buyers in time to meet the other sides of these trades, and we can't because no one can think fast enough or act fast enough.

In the interim, what you need to do is protect yourself from hedge funds gone wild, and the only way I know to do that is with dividends. Then, at least, there is some fundamental grounding. We will hit bottom here when so many stocks yield such high amounts that we are at last at a level where when the stocks are forced down they simply aren't worth selling.

But make no mistake about it, if you want to see the volatility end and the situation get better, you need to see all of the Citadels blown up or bailed out, and believe me -- as bailout-happy as we have become, Ken Griffin's going to have to come back on his own.

At the time of publication, Cramer had no positions in the stocks mentioned.

Show Comments

Back to Top