A couple of weeks ago one of the greatest traders who has ever lived was interviewed on CNBC. During the interview Stanley Druckenmiller warned that the Fed has created a bubble and that the exit was going to be extremely dicey. The part of the interview that I found most interesting was when the CNBC anchor asked about Stan’s current long positioning:
JOE KERNEN (CNBC ANCHOR): You knew you were about three or four years early before ’08. Okay. So we know where we are chronologically right now. You have been on Squawk Box and said as long as – you sound like Chuck Prince. You’re still dancing now basically. Until they raise rates you’re going to dance, right?
STAN DRUCKENMILLER: Not that age – first of all, I’m not like Chuck Prince because I can get out. I am still dancing, but Chuck Prince and the Fed, if they’re wrong, cannot get out. I can get out in a week.
Druckenmiller is long stocks and riding the current bubble because he “can get out in a week.” Think about that for a second. It is going to take Stan a week to sell his positions. How many hedge funds are thinking the exact same thing? How many are assuming that the liquidity will be there to exit their positions over the course of a week or two?
I used to think the chances of an equity crash were low. I figured that since the 2008 credit crisis was particularly ugly for equities, investors wouldn’t bid stocks up to levels that were prone to a crash. But the Fed’s six years of pushing investors out the risk curve has created a dangerous environment. I am no longer so sanguine about the potential for a crash.
It is all the more precarious because of preponderance of hedge funds. More and more the markets are nothing but a bunch of hedge funds sitting around in a circle shooting at the target in the middle. I have written about the series of rolling bubbles and I think that the bubble has moved into equities.
One of these days we are going to get a reason to sell. At that time these hedge funds that are all counting on liquidity are going to be shocked at the lack of bids.
The hedge funds move together like a herd, so if Stanley started selling, it wouldn’t take long before they would all be selling. Most of them manage more money that Stan because he is semi-retired and only oversees his personal money. Imagine what an ugly month that will be if they were all hitting bids.
Today the buying feels relentless and unstoppable. But I worry that it wouldn’t take much to shift that same feeling to the sell side. And fear is always stronger than greed.
I don’t know what is going to trigger the turn. And we know that trying to time the turn is even more difficult than predicting the cause.
But the risks are way higher than most market participants realize. The smartest investors in the world are all counting on playing this game of hot potato with the idea of hitting bids aggressively once it does turn. When they do decide to pull the rip cord, it is going to cause a stampede out of stocks like we haven’t seen in a long time.
I started trading in the early 1990s and at that time memories of the 1987 crash were always fresh in investors’ minds. Sometimes the selling would accelerate and there were concerns that we would have a repeat of the crash. The authorities instituted “circuit breakers” that halted the trading of stock index futures for a couple of hours when they declined by a preset amount. These self imposed time outs did a good job of slowing down the selling, but I remember days of one limit being lifted and the futures quickly skidding down to the second limit. I was sitting on an institutional trading desk and when the first limit would be hit, trading would dry up completely. All the orders would be pulled and the institutional investors would wait until the trading in the stock index futures would once again commence before returning to the market. It did slow down the selling and stop it from cascading lower too quickly, but it was always nerve wracking. My job was the index arbitrage trader. Buying the cash market 2% below the futures fair value last in the hopes of locking in the arb once the halt was lifted is a trade that I am glad I don’t need to worry about anymore…
Although today’s traders are most likely well aware of individual stock price limits, it has been so long since the general market has experienced this sort of volatility that many are probably unaware that there are also stock index limits. I worry that we will be all too soon reacquainted with these limits.