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Play Ball!

By

It's an exciting time to be in the game.

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"The first two were high and tight, so where do you think the next one's gonna be?"
-
Shoeless Joe Jackson, Field of Dreams


You can almost smell fresh cut grass and a hint of leather in the air. With October in our sights, the end-of-quarter pay-off chase is in full swing as players dig in their cleats and take last licks. That steady buzz you hear is the anxious crowd waiting for the final standings to post. Fund managers have been dealt a healthy hand of wild cards this past month and the rookies are being unmasked in kind.

It's an exciting time to be in the game. As headlines of new highs abound, investors are being forced to choose a team or step aside. In one dugout, we've got the bovine beauties, emboldened by the action in the homebuilders and the technical affirmation of the S&P. On the other side, the ursine uglies are fielding non-confirmations in the transports, mid-caps, small-caps and internals.

At stake is a world series of profits that will make or break reputations and bank accounts alike.
The hedge fund phenomenon is nothing new. Much like the housing bubble and net names before it, the signs of excess have long been evident. The elasticity was masked by a massive injection of liquidity that, in turn, caused a compression of volatility that allowed fund managers to slosh around behind the scenes. The heretofore victim has been the U.S. dollar, the "other side" of equity gains, but a seismic shift is seemingly underway.

Veteran traders are all-too-familiar with the caveats of contagion. Nobody really cared about the Thai Baht until it hit their bottom line. Long-Term Capital was an anomaly until the extensive counter-party risk was exposed. Russian Rubles? Nyet a concern until the cold war turned into a hot topic. The simple truth is that nobody will identify the pin prick without the benefit of hindsight or the validation of price.

The saga of Amaranth Advisors has been well publicized. But to cast blame or point fingers at this organization, while warranted, is potentially missing the point. While hedge funds have assumed an integral role in the market machination through liquidity transfer and risk assumption--playing the part that a broker-dealer once served--risk-management controls and regulatory oversight have lagged considerably. Amaranth shouldn't come as a shocker, nor should the steady stream of culprits that are sure to follow.

The risk to the broader tape isn't a function of the multitude or magnitude of these funds, which controlled $1.25 trillion at the end of the second quarter (Hedge Fund Research, Inc.). My concerns are the leverage employed to capture returns in a low volatility environment--remember, hedgies are paid to perform--and, perhaps more important, the correlation of strategies that are currently in play. With so many teams on the same side of the field, the imbalance is almost palpable.

While the mainstream media spins the carnage in commodities, down 15% this past month alone, as a boon to the consumer, investors would be wise to keep an open mind as we watch these pebbles hit the pond. Betting on a "tail event," such as financial contagion, is a low probability affair but the interwoven financial fabric, coupled with historically low levels of volatility and a universal acceptance of new highs, begs discipline if not caution.

The race to quarter-end--and year-end behind it--will be a vicious battle between perception and reality. Performance anxiety is a powerful motivation and could very well spur the herd in the race to get paid. But for every reward there is an attendant risk and it's quite possible that the line-up of dark side catalysts, from adjustable rate mortgages to cumulative debt, are akin to rain delays that have managers swinging for the fences while the game is still being played.

A smart man once said, "Don't hate the player, hate the game." I can't help but wonder how the game will change if the players themselves begin to hate it.

Good luck today.

R.P.
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