Saturday, November 14, 2009

Crowded trades

The most obvious good trades often become crowded. This is not surprising. As we know from behavioral finance, if you don’t know what you’re doing often the best course is to follow the smart(er) money. Hedge fund after hedge fund, prop trader after prop trader, and sometimes (and usually belatedly) the retail trader pile on. They continue to make money as the trade moves in their favor. The problem is how to exit.

Let’s think in terms of analogies. You’re in Oliver Wendell Holmes’s proverbial crowded theater. It’s crowded for a reason; the play has received rave reviews and everybody wants to see it. If you are totally engrossed in the play, you are unaware of any potential dangers. You are enthralled with the play and naturally expect to leave the theater only after the final curtain call. If, by contrast, you are hypersensitive to risk, you may sense smoke coming from a bored patron hanging out in the lobby puffing away. You know the adage “Where there’s smoke there’s fire” only too well and decide to leave the theater. After all, you’ve enjoyed at least part of the play and decide there’s no reason to risk being burned or worse to see it all the way through.

Like most analogies, this one is starting to be forced, but I want to give it one more push. The “best” seats—that is, the most expensive seats—in the theater are in the center sections, not in the wings. That is, they are farthest away from the exits. They are not occupied by the usual patrons of the arts, by the movers and shakers, but by those who on this occasion outbid the usual occupants. In fact, smack dab in the middle is the so-called dumb money, the retail trader.

The smart(er) money isn’t enjoying the play nearly as much as the dumb(er) money. They have to crane their necks to see properly, and they’re experiencing a little draft from the exit doors. They, by the way, smell no smoke but they’re not completely comfortable either.

You know how the story unfolds. Someone cries “Fire!” and everyone rushes for the exits. Those closest to the exits get out, the next wave may be crushed, and if the cry of “fire” was not a false alarm, those in the middle are most likely to die.

As with most analogies, this one is oversimplified. It doesn’t consider the effects of leverage, it elevates smart money to heights that are often unwarranted, and it assumes that someone actually cries “Fire!” (which, as we know, doesn’t happen in markets). Moreover, it doesn’t take into consideration what might happen to adjacent buildings, better known as the rest of the portfolio, if there actually is a fire.

Right now the leveraged dollar carry-trade is crowded. Although we’ve heard warnings from the usual suspects (see, for instance, Roubini’s piece in the Financial Times, I would add an article from the India Times entitled “Perils of dollar carry trade” that offers a slightly different perspective.

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