Reply #23: What the Next 6 Months Holds For Investors

[54anickel]

Looking Back at 2004 and the Impact of Hedge Funds on the Market

http://wallstreetwindow.com/goldarticle012405.htm

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2005 - A Shaky Start for the Markets

I feel a little uneasy about the huge growth in hedge funds over the past few years. The late 1990’s bull market was driven by huge injections of liquidity into the financial system. This gave rise to the Internet bull market and the post March 2000 bear market bust and recession. In many ways, the speculative excesses of the 1990’s in the stock market and the economy have not been worked off. Instead liquidity has floated through one sector of the financial system into another - whether it be in real estate, the bond market, even record levels of volume on the penny stock OTCBB exchange in 2003, rising commodity prices, and now in hedge funds. The S&P 500 currently trades at 21 times earnings and gives investors a microscopic dividend yield of 1.8%.

Much was made a year ago about the four-year election cycle. Many experts and analysts made note of the fact that the market historically rallies during a Presidential year. What is also true is that post-election rallies tend to fade between the middle of December and January with large declines the following year. In fact, the year of a Presidential election has usually been the most bullish year in the markets and the year after the most bearish.

I believe that last year’s fourth quarterly rally was fueled by hedge funds that made a self-fulfilling prophecy out of the four-year Presidential cycle election. They bought and bought, pyramiding the market high. As soon as the calendar year changed and their 2004 books were closed they sold, creating massive volume on the Nasdaq and the NYSE, all to the downside.

If this is indeed what has happened, then such a rally has been driven by liquidity, speculation, and the current structure of the financial markets themselves - dominated by hedge funds and program trading - and not by real fundamentals. Even the Federal Reserve has seen signs that this may be the case. According to the minutes of the Fed’s December FOMC meeting:
"Some participants believed that the prolonged period of (monetary) policy accommodation had generated a significant degree of liquidity that might be contributing to signs of excessive risk taking in financial markets evidenced by quite narrow credit spreads, a pick-up in initial public offerings, an upturn in mergers and acquisitions activity, and anecdotal reports that speculative demands were becoming apparent in the markets for family homes and condominiums."

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Going into 2005, we are in a situation where low long-term interest rates are showing a sign of high confidence by investors in Alan Greenspan and the Federal Reserve, despite an annual inflation rate of 3.3% for 2004, while hedge funds and program trading has turned the financial markets into something of a casino.

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