Why Hedge Fund Hot Shots Finally Got Hammered

The destruction of honest financial markets by the Fed and other central banks has created a class of hedge fund hot shots that are truly hard to take. Many of them have been riding the bubble ever since Alan Greenspan got it going after the crash of 1987 and now not only claim to be investment geniuses, but also get downright huffy if the Fed or anyone else threatens to roil the casino.

Leon Cooperman, who is an ex-Goldman trader and now proprietor of a giant fund called Omega Advisors, is one of the more insufferable blowhards among these billionaire bubble riders. Earlier this week he proved that in spades.

It seems that his fund had a thundering loss of more than 10% in August during a downdraft in the stock market that the Fed for once took no action to counter. But rather than accept responsibility for the fact that his portfolio of momo stocks took a dive during a wobbly tape, Cooperman put out a screed blaming the purportedly unfair tactics of other casino gamblers:

Lee Cooperman, the founder of Omega Advisors, has joined the growing chorus of investors blaming last week’s stock market sell-off — and his own poor performance in August — on esoteric but increasingly influential trading strategies pioneered by hedge funds like Bridgewater.

Well now. Exactly how was Bridgewater counting the cards so as to cause such a ruction at the gaming tables?

In a word, Ray Dalio, the storied founder of the giant Bridgewater "All-Weather" risk parity fund, has been doing the same thing as Cooperman, and for nearly as many decades. Namely, counting the cards held-out in plain public view by the foolish monetary central planners domiciled in the Eccles Building.

To be sure, Dalio's fund has had superlative returns and there is undoubtedly some serious algorithmic magic embedded in Bridgewater's computers. But at the end of the day its all a function of broken capital markets that have been usurped and rigged by the Fed.

The only thing your need to know about the vaunted "risk parity" strategies that have served Bridgewater and their imitators so handsomely, and which have now aroused the ire of more primitive gamblers like Cooperman, is the graph below:
^SPX Chart

^SPX data by YCharts

The above, of course, is the Fed's "wealth effects" printing press at work. There have been about 30 identifiable "dips" since the March 2009 low and every one of them have been bought by the casino gamblers. And for good reason.

The Bernanke Fed's egregious, desperate and utterly unwarranted bailout of Wall Street at the time of the post-Lehman crash taught the gamblers a profound lesson. That is, they could be exceedingly confident that the Fed would keep the free money flowing at all hazards, and that it would resort to any price rigging intervention as might be necessary to keep the stock averages rising.

Indeed, never in all of history have a few ten thousand punters made so many trillions in return for so little economic value added. But what Dalio did in this context was to invent an even more efficient machine to strip-mine the Fed's monumental largesse.

To wit, Bridgewater's computers buy more stocks on the "rips", when equity volatility is falling and prices are rising; and then on the "dips" they rotate funds into more bonds when equity volatility is rising and the herd is retreating to the safe haven of treasuries and other fixed income securities, thereby causing the price of the latter to rise.

In short, there is a payday in every type of short-run financial weather because Bridgewater's computers are monetary sump pumps; they constantly purge volatility from the portfolio.

But here's the thing. The above chart could never exist in an honest free market.

You couldn't create algorithms to safely pump out volatility and milk the market on alternating strokes because the regularity of the waves on which it is based are not natural; they are the handiwork a central bank that has been taken hostage by the casino gamblers.

Nor is "hostage" too strong a word. In the days of Paul Volcker and William McChesney Martin anybody who even speculated about 80 months of ZIRP would have been assigned to the William Jennings Bryan school of monetary crankery.

As it happened, however, in the last few weeks the long reign of the global money printers has begun to sprout fractures. Over on the other side of the earth in China what had become a 20-year long $4 trillion cumulative "bid" for US treasuries and other DM fixed income securities has gone serious "offers".

This will prove to be one of the great financial pivots of history. During the course of their stupendous inflation of China's $28 trillion Credit Ponzi, the red suzerains of Beijing bought treasuries hand over fist and thereby kept their price rising and the volatility of the world bond market falling.

To be sure, this wasn't charity for America's debt besotted shoppers and governments. It was done in order to peg the RMB exchange rate and thereby keep its mercantilist export machine humming and the people grateful to their beneficent  communist party rulers.

But at length it became too much of a good thing because every time the Peoples Bank Of China (PBOC) bought Uncle Sam's debt it similtaneously expanded the internal banking system and supply of RMB credit. Moreover, after Beijing launched its madcap infrastructure building campaign in response to the the 2008 financial crisis the phony construction and investment boom which ensued attracted increasing waves of hot money from abroad, thereby inflating the domestic Chinese economy to a fever pitch.

In fact, the PBOC was forced to let the RMB slowly rise against the dollar to keep its banking system from becoming a financial runaway. But the steadily rising RMB drastically accelerated the inflow of foreign capital and speculative funds into the Chinese economy, thereby filling the vaults of the PBOC to the brim at more than $4 trillion early this year compared to a few hundred billion at the turn of the century.

China Foreign Exchange Reserves

But these weren't monetary reserves in any meaningful or historic sense of the term; they were the fruits of an utterly stupid mercantilist trade policy and the conversion of a naïve old man, and survivor of Mao's depredations, to the view that communist party power could be better administered from the end of a printing press than from the barrel of a gun.

But Mr. Deng merely unleashed a Credit Monster that sucked in capital and resources from all over the globe into a domestic whirlpool of digging, building, borrowing, investing and speculation that was inherently unstable and incendiary. It was only a matter of time before this edifice of economic madness began to wobble and sway and to eventually buckle entirely.

That time came in 2015----roughly 30 years after Mr. Deng proclaimed it is glorious to be rich. So saying, he did not have a clue that a credit swollen simulacrum of capitalism run by communist apparatchiks was a doomsday machine.

In any event, what is happening in China now is that the speculators----both domestic and foreign-----see that the jig is up. That is especially the case after Beijing's incredibly botched effort to alleviate its massive corporate debt problem by inciting a $5 trillion stock market bubble that is now being blown to smithereens.

This has happened notwithstanding the party bosses sending out truckloads of cash to arrest the stock market's collapse and then doubling down by sending fleets of paddy wagons to arrest any one who might be tempted into overzealous offers to sell what the PBOC is trying to buy. It means that confidence in the Red Ponzi has at last been shattered.

Accordingly, money is leaking out of China thru a thousand rivulets, by-ways and financial back alleys.  To prevent the RMB exchange rate from plunging and thereby inciting even more capital fright and flight, the PBOC has shifted into reverse gear in a large, sustained and strategic way----as opposed to tactical FX management----- for the first time since the putative miracle of red capitalism incepted.

Ray Dalio wasn't counting on this because despite Bridgewater's proficiency in concocting trading algorithms, its vaunted macroeconomics staff consists of standard issue Keynesians----with a dash of Minskyites thrown in for good measure. Alas, they were not prepared for the possibility that Austrians have said is inevitable all along.

To wit, that Beijing's experiment with Red Capitalism would eventually end in a crackup boom, causing the seemingly endless Red Bid for US treasuries to become a disruptive and unwelcome Red Offer to sell hundreds of billions of said paper and like and similar dollar/euro/yen liabilities.

To make a long story short, during the gyrations of August bond prices didn't rise like they were supposed to when the stock market plunged by 12% to its Bullard Rip low at 1867 on the S&P 500. Accordingly, Bridgewater's risk party portfolio became swamped with too much volatility on both the bond and equity side of Dalio's big boat. So the algorithmic sump pumps went into over-time dumping stocks in order to drain the ship.

Consequently, Bridgewater wiped out its entire profits for the year in a few days during August, pushing the momo chasers like Cooperman into the drink in the process. Needless to say, the capsizing Big Boats in the casino are now firing at each other, but also lining-up for a full court press at the Eccles Building.

Ray Dalio has already said its time for QE4. He apparently realizes that the Fed's big fat bid is needed to replace the missing Red Bid in the treasury market, and thereby get his risk parity algorithms working again.

At the same time, Goldman today sent out its chief economist to pronounce that today's Jobs Friday report tipped the case to no rate increase at the Fed's upcoming September meeting. Why we need an 81st month of ZIRP when 80 months so far have not succeeded, he didn't say.

No matter. You can be sure of this. If the market holds above next week's retest of the 1967 Bullard Rip low, the Fed will likely announce a "one and done" move in September, causing the casino to stage a short-lived, half-heated rally.

By the same token, if the market drops through the Bullard Rip low, the Fed will plead market instability and defer its 25 bps pinprick yet again, thereby causing the same short-lived half-hearted rally.

What won't happen, however, is another leg higher in the phony bull market engineered by the Fed and its fellow- traveling central banks. That's because the global "dollar short" is finally coming home to roost.

For nearly two decades the central banks of EM mercantilists have been buying treasury paper, as have the commodity producers and the petro-states. So doing they have helped the Fed drive the benchmark rate to absurdly non-economic levels.

That's what happens when the printing press is used to generate $12 trillion of so-called FX reserves and $22 trillion of total footings for the consolidated monetary roach motels of the world, otherwise known as central banks and sovereign wealth funds.

In turn, this massive stash became the collateral for the private issuance of friskier dollar denominated corporate and sovereign credits throughout the EM world, thereby slacking the thirst for yield among desperate money managers.

But now China's house of cards is cratering, causing economies to plunge throughout the worldwide China supply chain. Witness Brazil where industrial production is down 8% from a year ago, and slipping rapidly from there; or South Korea where exports have plunged by double digits.

Metaphorically speaking, dollars are hightailing back to the Eccles building. China and the petro-states are selling and off-shore dollar lenders are effectively making a margin call.

At length, both the epic bond bubble and the monumental stock bubble so recklessly fueled by the Fed and the other central banks after September 2008 will burst in response to the deflationary tidal wave now cresting.

Needless to say, that eventuality will be the death knell for the risk parity trade. It will cause the volatility seeking algos to eat their own portfolios alive.

Can the masters of the universe hanging around in the Hedge Fund Hotels say "portfolio insurance"?

Leon Cooperman and his momo chasing compatriots will soon be praying for an event as mild as October 1987.

David Stockman's Contra Corner is the only place where mainstream delusions and cant about the Warfare State, the Bailout State, Bubble Finance and Beltway Banditry are ripped, refuted and rebuked. Subscribe now to receive David Stockman’s latest posts by email each day as well as his model portfolio, Lee Adler’s Daily Data Dive and David’s personally curated insights and analysis from leading contrarian thinkers.

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