One Shoe Dropping....

What is the sound of one shoe dropping? Squisssh? Plop? Crack? You can take you're pick. But what I CAN tell you is what it looks like (see picture left). This is a yearly chart of "BMNIX", the Laudus-Rosenberg Market Neutral Fund, an open-ended US Mutual Fund. It is a quantitative in nature (per Rosenberg's long experinence in risk-modeling), highly diversified (hundres of names long and hundreds short), uber-neutral, (thus equal amounts of long versus short stock), no leverage per-se, although it does, I will suggest, have some style bets, chiefly some small-cap, and some value. Which given current circumstances is about as appealing as eating a rotten oyster or (I can just about imagine) catching a venereal disease.

The Fund has a daily STDev of perhaps 0.35% at the outside, reflecting its well-hedged and diversified nature. What in Merriweather's name could possibly flatten this fund like 'possum-on-a-country-lane minus-seven-percent roadkill? Minus 7% in a week!! What is probability of THAT! Poor stockpicking? Happenstance? Black Swans? Pari-passu risk? We will see and hear more today.

Interestingly, Bloomberg has struck a deal with Algorithmics to make their risk software available on the Professional terminal. This includes, VAR, scenario analyses, and "stress-testing" where they take a variety of risks that scare the living pooh out of risk managers (and principals) alike: "Sept 11", "Flight-to_Quality" , "Small-Cap Puke", "Rising Rates", "Fading Recovery". But as I suggested yesterday., the risk that will inevitably bite investors' collective arses will be the risk that has not been seen before. In this case, that risk is a systemic de-leveraging cascade. This is different than a flight to quality. A "flight-to-quality" substitutes low risk assets for high-risk assets. Systemic de-leveraging destroys both assets AND liabilities, shaking up the co-variance matrix of relative pricing in the process, and most-likely laying waste to lots of excess in asset prices.

BMNIX's rapid price destruction is the tip of but one shoe to drop, the reflection of some's forced liquidation. But sitting atop this , are a whole array of expensive securities squeezed up by passing temporary demands for liquidity, but which entropy will inevitably see return to more sensible levels, so dropping the second shoe. The bold will short them hard as others are squeezed. Most will watch in awe and wonderment. THe carnage will yield wonderful medium-term opportunities to buy assets on the cheap, from those who surfed too-close to the edge and perhaps terminally de-boarded...