Remember those days in school when the teacher would leave the room?
At first, it would always just be the kids in the back of the class cutting up. They might start whispering inappropriate jokes or throwing spitballs.
But if the teacher stayed away long enough, more kids would start to get in on the act.
After a while, the whole classroom would be in a state of chaos — at least until an adult came back in the room.
And then if you had a strict teacher or principal, there was hell to pay!
The same scenario is happening in the market right now. And as the adults step back into the room and restore order, some big changes are about to happen!
Today, we’re going to talk about what to expect from this shift. And I’ll let you know:
- What to watch out for, and
- how to profit from this change.
Let’s get started!
Time for Hedge Funds to Stop Acting Like Children
Last month, markets reacted sharply to the implosion of Archegos, a multi-billion-dollar family office structured much like a hedge fund.
The fund borrowed heavily from its brokers to buy billions of dollars worth of stock.
Once the shares it bought started trading lower, Archegos was essentially wiped out.
It couldn’t pay back the brokers. And the brokers had to quickly sell the shares that Archegos had bought to try to recoup some of their losses.
Whenever you have billions of dollars of stock being sold in a panic like that, it causes some big disruptions in the market.
Now that the dust has settled, the largest brokers are rethinking the way they want to do business with hedge funds.
Just in the past week, Bloomberg printed multiple articles about how brokers like Credit Suisse and Tokyo-based Nomura Holdings are tightening the limits on how much hedge funds can borrow.
It’s as if the adults (or the brokers who could be on the hook for big losses if hedge funds blow up) have finally entered the room and told the kids to settle down.
The billions in loans to help buy more shares will now be reduced. And hedge funds will have to trim their biggest positions.
So what does that mean for markets — and for us?
The Good and the Bad Side of Hedge Fund Sanity
As prime brokers place stricter limits on how much risk hedge funds can take, it will cause ripples in the market.
Some of these changes will be very good. And some could create some sticky situations for speculative investors.
On one hand, I feel much more comfortable knowing that brokers are getting a bit restrictive with hedge funds. After all, I’ve seen how these funds can blow up first hand!
The hedge fund that I worked at was a very conservative shop.
My boss Bill thought it was extremely important to protect our clients’ wealth. So we never borrowed heavily to take big positions that could risk blowing up.
But I saw plenty of my colleagues in the industry take advantage of these loans.
And when the financial crisis of 2008 hit, many of these colleagues lost everything! (Worse, they lost everything that their customers trusted them to manage.)
So if this situation with Archegos causes brokers and hedge funds to be more careful with how they invest, it could keep us from having a much more widespread market crash from multiple hedge funds blowing up.
That’s the good news.
But the bad news is that with brokers not willing to lend as much to their hedge fund clients, we’re likely to see these funds have to sell some big positions over the next few weeks.
After all, the hedge funds will have to free up cash to pay back some of these excessive loans that are now being taken away.
This means we could see some speculative stocks sell off sharply. And if you’re invested in these plays while hedge funds unload their shares, you could get caught in a vicious cycle!
As hedge funds sell their positions, individual investors will see prices start to drop.
And this could cause a mini-panic for people who hold these specific stocks. If everyone heads for the exits at the same time, shares could drop sharply causing big losses.
The best way to avoid this situation is to sell out of these stocks now before the brokers implement new rules and force the hedge funds to sell.
The stocks you should be particularly concerned with are the ones with low earnings (or no earnings yet) and very high stock prices.
These speculative names have the farthest to fall and will likely take the longest to rebound.
The Hidden Opportunity as Hedge Funds Sell
If we wind up in a situation where there’s wholesale selling from some of the biggest hedge funds, even good stocks will likely be sent lower.
This is where you can turn the situation to your advantage and make some big profits!
Many hedge funds have taken big positions in turnaround plays that do have strong earnings.
In some cases, these hedge funds are activist investors and have put their own representatives on the board of these companies to help turn the businesses around.
If a broker decides not to lend money to a hedge fund and that fund has to sell shares, the stock will likely drop. But that doesn’t mean anything has changed at the company.
So if you wait for these good stocks to drop and then buy them at a discount, you’ll do quite well!
The company will continue to generate profits.
Businesses that are poised to benefit from the economic reopening will still recover.
And in time (possibly in a very short amount of time), these stocks will trade back up.
My team and I will be watching this situation closely and keeping tabs on which stocks are heavily owned by hedge funds.
The bad ones will trade lower and we’re happy to avoid them.
But when good stocks temporarily decline because of hedge fund selling, we’ll be pounding the table and letting you know when to buy.
Picking up great companies at a discount price is an excellent way to grow your wealth!
So stay tuned as this hedge fund story plays out. You might find some of your favorite stocks on sale soon!