1994 Redux: Beware of the Fed Meeting

Editor's note: This is the second in a week-long series titled "1994 Redux," which compares current market conditions to those of six years ago.

Just how grueling was 1994? What still awaits us as this parallel year unfolds? Consider what happened to our firm six years ago next week.

Then, as now, we were playing it lean. Then, as now, we had shorts on and plenty of cash. Then, as now, we were struggling every day to try to find opportunities to make money as the Fed raised rates steadily and mercilessly.

We tried to approach the whole market from the point of view of the Fed. It was commodity inflation that was roaring then and the Fed wanted to kill that commodity inflation. So what we did was short all of the commodity producers, companies like Dow Chemical(DOW) and Dupont (DD) and Phelps Dodge (PD) and Alcoa (AA).

We knew that ultimately the cyclicals would have to bear the brunt of the Fed's tightening and we needed to balance our longs -- chiefly tech, but some value-oriented savings and loans (more on those in a subsequent part of the series) -- with these shorts in order to make money.

There was only one problem. Hundreds of other hedge funds were doing the same thing. Hundreds of other hedge funds were making the same set of bets. Meanwhile, others -- chiefly an overly optimistic camp of buyers -- were always looking for opportunities, betting that the Fed would be able to stop tightening sometime soon.

Sound familiar? We have the same dichotomy this year.

Coming into the May 17, 1994 meeting we were loaded to the gills with puts and shorts on the cyclicals. We had been disciplined about the shorts, trying not to put them on all at one level, but they were big positions considering that our fund was about a third of its current size.

At the time, my wife, Karen, was pregnant with our second child. Her due date was the week before the meeting, but, heck, some things in life are pretty unplanned.

The morning of the Fed meeting she knew she was ready. I called the office and told everybody that I wasn't coming in and to call only if there was an emergency, but that I would leave my cell phone on. At 2:16 p.m., my wife gave birth to a beautiful baby girl. At 2:17 p.m., my cell phone rang. It was Jeff. The Fed had tightened and the cyclicals were rallying. What should we do? My wife looked up at me and asked who I was talking to. I told her that it was Jeff. She wanted to know how he knew to call right then?

I explained to her that he was calling because the Fed just tightened 50 basis points and our shorts were getting squeezed. I figure that in another 6 years she will actually forgive me for having that conversation at that moment. I can't believe my daughter ever will!

Anyway, I had the good sense to tell Jeff that I had to call him back later -- genius!! -- and I returned to the more important matters at hand, our new daughter and her very tired mother.

The next day, while at the hospital, I got another call. Same thing, the shorts were ramping, just killing us, and the financials weren't making up for the difference. I stepped into the hospital hallway and began screaming into the phone to cover everything, that I couldn't take it, I wanted to spend some time with our first child so that she knew she felt special as ever, despite the hubbub over the new baby. We took off almost every short, in a virtual frenzy of buying.

The pain went away.

Of course, our covering created a short-term top in these cyclicals, as it soon became evident that the Fed was by no means done tightening. They would begin a sickening decline that would take them to their lows at the end of the year as the Fed seemed quite willing to take a recession to break the economy.

But that's just the way it was. Whatever made the least sense happened, in part because so many people were trying to game it using rational thinking. Those two days were a total microcosm for 1994. And that year was one of those years that you ended up regretting that you were in the business.

The one big difference between this year and 1994 is the ranks of the hedge funds out there -- and by all means I include all individual traders who trade all day (didn't call you daytraders) as hedge fund managers -- has to be 30 or 40 times larger than six years ago.

I am betting that it will be 30 or 40 more times irrational when we are through with this wacky rerun of that terrible year.

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(Tomorrow, what stocks worked best in 1994.)

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