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9:00 AM EST, Wednesday, November 5, 2008: Investors are deserting hedge funds in droves. Some hedge funds are closing. Some hedge funds are suspending redemptions. Most are simply dumping their stocks to pay off their itchy investors and, for many, to pay off the banks which lent them money.

There is no question that worldwide stockmarkets will be under huge selling pressure between now and the end of the year. That -- and our lousy, worsening economy -- are why I am not calling for a wholesale re-entry, despite the nice markets of the last several days.

I recently asked my friend, a senior editor at the Economist, why his magazine was doing so well and other business magazines, e.g. BusinessWeek and Fortune, were doing so awfully. He said the Economist's secret was simple: they believed that to discuss business you had to discuss politics. His competitors believed they were distinct, separate animals. Look at Zimbabwe for the idiocy of that "logic." Look at the damage wrought by the Bush administration of the past eight years. And the next eight years? Major slogging. Hard times. But ultimately major recovery. I'm very optimistic this morning. It's nice to have a new president with fresh, new ideas.

Exhibit 1:

Exhibit 2: From today's InvestmentPostcards:

When chickens come home to roost.

My big worry at the moment is what is happening to (some) hedge funds. Clearly, 2008 has been to hedge fund investors what 1992 was to Queen Elizabeth II – Annus Horribilis (see chart 1).

Chart 1: Selected hedge fund strategies (YTD performance)

Source: The Economist

Merrill Lynch did a study recently, showing that the 30 biggest US equity holdings amongst US hedge funds were amongst the poorest performers in the S&P500. In other words, it is likely that much of the recent sell-off in equity markets around the world can be traced back to hedge fund liquidations.

There is no question that hedge funds are downsizing at present. The problem is to obtain precise data on the phenomenon. If we estimate that the global hedge fund industry controls about $2 trillion of capital, and we assume that 15-20% is going to be pulled out between now and year-end (which is not far from the truth according to our sources), $3-400 billion must be returned to investors between now and 31st December.

Deleveraging continues
That is not the whole story though. The average hedge fund uses leverage, to the tune of about 1.4 times (see chart 2). This is down significantly from a year ago, but it still means that hedge funds need to liquidate investments of at least $500-550 billion in order to meet current redemption requests. And the real number is probably higher because some of the worst performing strategies this year are the ones using the most leverage. The real number is therefore more likely $6-800 billion, and that is a big enough sum of money to put downward pressure on the markets.

Add to this the fact that some hedge funds (mostly the bigger ones) have been selling credit default swaps (CDSs). A CDS is an insurance against corporate default. The buyer of a CDS supposedly makes money if the underlying credit blows up. I say ‘supposedly’ because the payment is a function of the seller’s ability to pay up. That was why Morgan Stanley had to be saved at all cost. MS has been, and continues to be, one of the largest players in the CDS market.

Chart 2: Average hedge fund leverage

There is no way we can establish precisely how many CDSs hedge funds have on their books, but please consider the following: The CDS market is a $50 trillion market (give or take). Before they blew up, AIG were one of the biggest sellers of CDSs with approximately $500 billion on their books. They ran into problems (partly) because they were heavily exposed to the financial services industry which is already in recession.

Recession in the early stages
The rest of the economy, however, is not yet in recession – or rather, we do not have the statistics to prove it. Corporate defaults are still low, both here and in the US. But corporate defaults will go up as they always do in recessions. If AIG, one of the largest and most sophisticated financial institutions could get themselves into trouble with barely a 1% share of the global CDS market, what will happen to the sellers of the remaining 99%?

Who ‘owns’ this risk? Is it hedged or not? Is it even possible to hedge the risk, knowing that your counterparty might not be able to pay up? What we do know is that only the larger hedge funds have participated in the practise of selling CDSs. Right now it feels very good not to be invested in those types of hedge funds (as you may be aware, our focus is on alternative investment strategies away from mainstream hedge funds). I also suspect that the extreme volatility in recent weeks is somehow related to this phenomenon. Investor redemptions are not the whole story.

Conclusion
I pointed out several months ago that the world’s stock markets would present several ‘false dawns’ before we could finally declare victory against the bear market. Last week’s more upbeat tone was one such ‘false dawn’, in my opinion. There are three reasons for that:

Firstly, investors have not yet fully capitulated, and that is a necessary condition for markets to turn around. It is best illustrated by a survey conducted by BCA Research at the end of their two-day investment conference held in New York on 20-21st October. Only five or six of the more than 250 people in the room expected the stock market to be lower a year from now. Not consistent with capitulation! Having said that, it is perfectly normal to experience powerful rallies in the midst of a major bear market. The sharpest rallies in history have actually been bear market rallies.

Secondly, de-leveraging has a long way to run yet, not so much in the hedge fund community where I suspect that much of the damage will be behind us once we pass the next major redemption hurdle on 31st December, but in society more broadly. Governments, banks, (some but not all) companies and, most importantly, the majority of households are more leveraged than good is. I have borrowed Chart 3 below from BCA Research, and it shows total US bank loans as a percentage of US GDP. Unfortunately, the picture would be much the same for many of the European countries. We are now facing a major de-leveraging cycle and it will suppress economic growth and put a lid on the stock market for years to come.

Chart 3: Major deleveraging cycle ahead

Source: BCA Research

Thirdly, whereas I fully agree that the worst of the financial crisis might now be behind us, bear in mind that we have not yet seen the full effect of the economic crisis. We are only in the first or second innings of this recession, and the emerging market story has the potential to wreak further havoc. So do credit default swaps - or something else. Recessions are by nature quite unpredictable. There is one thing I am sure about, though. Just as for New Year’s Eve, the more extravagant the party, the bigger the hangover. Prepare for this one to linger for a while yet.

Rupert Murdoch thinks Harry Newton (i.e. me) is an idiot. I have received a second mailed invoice from the Wall Street Journal for $299 for a one year subscription.

Yet I can go to the Journal's web site and, guess what? I can get the same one-year subscription for $103 (click here) Do I look like a total idiot?

There's a lesson here. Print media (like magazines and newspapers) are so desperate for money, they're doing desperate things -- like billing you a year in advance, like charging you nonsense high prices (like the Journal).

I put the Journal on a month "vacation hold." I've been without the paper version for the last two weeks. I have survived.

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.