Trader’s Narrative

Last year saw an epic battle between two giant hedge funds over the natural gas market: Amaranth Advisors and Centaurus Energy LP. The two funds went head-to-head in a winner take all battle royale. The result was a massive flow of assets from one small group of people to another. Amaranth and the trader responsible for their bullish natural gas bet, Torontonian Brian Hunter, were demolished by the bear: Texan John Arnold of Centaurus Energy.

It was great fun for me to read about the story of natural gas because it reminded me of the way things worked on Wall St. in the time of Jesse Livermore with pools pitting their wits and capital against the public and other pools. The only thing that has changed is that outright manipulation is a bit harder these days thanks to stricter regulation. Everything else is pretty much the same.

The big score propelled Centaurus (fee structure of 3/30) and Arnold to the top of fund performance ratings. Arnold’s performance since starting in 2002 is simply breathtaking. He’s finished every year 200%+!!

And although the loser in this, Brian Hunter is doing much better than the Amaranth investors. He’s still has the couple hundred million he made before he nuked Amaranth and being quite cheeky, he’s actually shopping around a new fund!

Report Card Time:
The first time I mentioned natural gas was on June 1st 2006 (leftmost green arrow on chart). I was bullish and it sort of worked out. But at best I would give this call a C+. The second time I mentioned natural gas was on September 21st 2006 (rightmost green arrow on chart):

I suspect that Amaranth’s exit from the energy arena is a tell that natural gas will find support here and retrace some of its decline.

That second call is an A+ But why did I claim it was a tell? When you’ve got a player with a very large position going against them, sooner or later they will have to liquidate - either by their own choice or their prime broker’s. And as soon as they unwind their position, that will mean putting the breaks on the trend because they will be applying liquidity the other way.

Think of it as a string with a weight on one end that is twirling in one direction. It reaches a point where its acceleration slows, then stops and then reverses. This is exactly what happened. An inflection point was reached when Amaranth couldn’t sustain their long position anymore. They wanted to get out and Centaurus wanted to ring the cash register.

Amaranth Advisor’s spectacular implosion has been all over the major newspapers, business tv and countless blogs so I won’t rehash the story of how a supposedly ‘hedged’ fund made a tragic bet on natural gas and kept doubling down. We’ve all seen this classic pattern accompany each and every historic blow-up.

But for me the most interesting aspect of Amaranth’s story is that it could very well be a tell for the Natural Gas market. If your memory stretches that far, think back to the late 90’s when TMT was all the rage and everyone and their puppy wanted to get in on that ’space’. But over in the dank and dark corner of gold stocks and dedicated bear mutual funds managers were busy closing shop.

I’ve been bullish on natural gas for a while now but it hasn’t worked out really. And in case you’re wondering, I’m still bullish. I suspect that Amaranth’s exit from the energy arena is a tell that natural gas will find support here and retrace some of its decline.

Because it’s dangerous to go against the trend I would not play this with Natural Gas futures itself. It’s way too volatile. Instead I would go for an equity proxy like natural gas stocks or Canadian energy trusts that are heavily weighted towards NG.

The private and reclusive Jim Simons (the founder and head of Renaissance Technologies) wants to improve the math skills of American kids. To that end he’s started a foundation called Math for America and pledged $50 million of his own money (loose change for Simons). The purpose of the program is to financially motivate top graduates of universities and colleges to go on to teach math.

Interestingly enough around 40% of public school math teachers in the US do not have a degree in math. And the result is that the US is placing almost dead last in a world wide ranking of student math proficiency.

Of course, a cynic might say that Simons is only watching out for himself since his hedge fund is powered by the top minds from MIT and other Ivy schools. But I think he is truly motivated by benevolence. After all he’s got all the money he will every need and he will be long dead before this program yields results.

Click here for the whole article.

Victor Niederhoffer’s Matador Fund lost almost a third of its assets in May. If you know about Vic’s history this isn’t that surprising. The timing is interesting as he was just emerging from the shadow of his spectacular blow up in 1997 with great performance in his fund, a feature article in Bloomberg magazine and honors from his peers.

Apparently he was massively leveraged on the long side into the slide (he perennially prefers the long side). It turns out that after all he still hasn’t learned humility (or risk management). The stock market is a wonderful teacher, but a very expensive one.

Consider what he said at the MARhedge party in April:

“The ridiculous thing, in all candor, is that I think I’ve had the greatest run of success in the history of speculation,”

Such extravagant and meaningless exaggeration is signature Niederhoffer.

Unless he can pull a rabbit of out of his proverbial hat, he’s going to go down in flames again. A drop of 30% means he has to earn 50% just to come back to where he was. Can he do it? Yes, it’s possible. But will his investors stick with him through such volatility? I doubt it. Most hedge funds, in fact, close up when faced with the task of climbing such a trough because even if they accomplish it (due to the high watermark) they’re not getting paid for that performance.

Here is a relevant excerpt from a recent Bloomberg article:

“I’m really humble about my ignorance,'’ says Jim Leitner of Falcon Management Corp., who estimates he’s made more than $2 billion for investors and employers in his trading career. “Many traders I’ve met over the years approach the market as if they’re smarter than other people. I have found this approach eventually leads to disaster when the market proves them wrong.'’

Indeed.