Expert View: Traders caught with their pants down as the tide ebbs

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The Independent Online

Anyone watching the broader stock market indices might conclude that everything is fine. Anyone working in the markets, however, thinks they are anything but.

Anyone watching the broader stock market indices might conclude that everything is fine. Anyone working in the markets, however, thinks they are anything but.

In particular, many of the traders who believed they had got it made after the past two years ... have just found out they haven't.

Markets aim to make fools of most people most of the time, and last week's strong equity rallies came at a time when almost everyone was feeling extremely gloomy. For many traders, not being in a market that goes up can be as bad as being in one that goes down. The reality is that the tide of almost free money that has driven all markets up over the past two years is ebbing away fast, and as Warren Buffett neatly put it: "When the tide goes out, you can see who isn't wearing shorts"

This goes right across all markets. The instant experts have moved on from the economics of China or the US dollar to the fine detail of complex derivative instruments. Papers are full of discussion about credit-default swaps and collateralised debt obligations.

We don't need to go into detail here, other than to say that a lot of people made a lot of money by borrowing a lot, and face the prospect of losing it all rather quickly as the process goes into reverse.

The situation is being made worse by the prospect of redemptions in many hedge funds next month. When a strategy starts to go wrong, investors ask for their money back. And that can make it a lot worse.

In some instances, the complex strategies of the hedge funds involved buying convertible bonds and selling the underlying stock "short". The spike in equity markets may well be down to their having to close those short positions in anticipation of investors wanting their money back. And markets like forced buyers as much as they like forced sellers.

Oil markets are another area where the traders have been caught out. They have now fallen almost a fifth since the beginning of April - good for oil consumers, not so good for producers, and even worse for traders. As is often the case, this has little to do with economic growth and a lot to do with speculative positions.

In a column last year, I argued that the, then soaring, oil price had little to do with booming demand from India and China (which was the widespread explanation at the time) and more to do with the panic buying by US refineries in the wake of disruptions following Hurricane Ivan. As such, I argued it was likely to subside, which it duly did.

The market spiked again after Christmas, however, and once again we heard the booming demand story - albeit with a twist of falling supply.

This narrative seemed to lose touch with reality in March as pundits talked of a "super-spike" to $100 a barrel, and net speculative positions in oil rose to record levels; the investment flashmob was well and truly in commodities.

As the markets came off, however, this produced an interesting condition in oil futures. Speculators leaving the short-dated futures market meant it was cheaper than the longer-dated futures. This made it profitable for oil producers to sell their product one year forward and store it rather than sell it on the spot market.

This of course has driven inventories up, and the inventory number is the key focus for traders in the spot market. So they have been selling even more, keeping it attractive for producers to sell into storage, forcing up inventories, panicking the spot market. And so on.

Now that it is going down, pundits will call for $30 oil in the same way they called for $100. But as we can see, they are deluding themselves.

Mark Tinker is a director of Execution Stockbrokers. mark.tinker@executionlimited.com

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