What’s the REAL reason the market fell?

Last Friday was one of those days that totally confounded some investors.

Take the fundamental economic news. It was pretty solid. The U.S. economy created 192,000 jobs in March, while February’s reading was revised upward, to 197,000. Unemployment held at 6.7 percent, while the average workweek ticked up by 0.2 hours.

As a matter of fact, private employment has now topped its pre-recession peak of 116 million. That confirms what I’ve been saying for some time: While growth is by no means gangbusters, there is no recession out there, and slow and steady improvement is still the name of the game.

So what happened? After a brief early rise, the Nasdaq Composite shed more than 110 points that day alone, while the Dow lost more than 300 over the next two trading days.

Selling that had been contained to a few momentum stocks spread into other corners of the market, including the financials. All told, it was the most severe selling squall in some sectors in three years.

When you see major swings in the market, you often get “forced” selling from gun-slinging funds.

So what’s the REAL reason the market fell?

Well, I think you can rule out fundamental developments. The jobs data wasn’t dismal. There weren’t any major corporate earnings warnings. Russia didn’t invade a new province in the Ukraine, nor did some new emerging market blow up overseas.

Instead, I think it goes back to a simple explanation — fund dumping, particularly hedge funds. One Goldman Sachs report quoted at the financial blog Zero Hedge said that its hedge fund-tracking basket just suffered its worst performance since May 2001.

A separate report in the Wall Street Journal suggested a handful of mega-funds lost more in just a few days than they had in years. Long positions fell, short positions rose, and overall performance tanked — with at least one fund losing 18 percent in March alone.

When you see major swings like this, you often get “forced” selling from gun-slinging funds that used too much leverage to boost returns. In other words, they borrowed money to amplify their returns in the recent “up” market. And when positions moved against them, they were forced to dump positions to cover those loans.

So is this a bigger problem for the market? Something that lasts more than a few days, or that could lead to an outright bear market?

I’m not concerned about that … yet. As I told you last week, the interest rate market isn’t signaling an imminent recession (Editor’s Note: If you want to learn more about how to “read” that market, just click here). The data on jobs, production, spending, confidence, and more don’t look like the kind of stuff you see when the economy is falling off a cliff.

Moreover, I don’t believe this is like 1999-2000. That’s when we had an all-out tech stock mania, one the underlying economy was hooked on for growth. Nor do I believe this is like 2004-2006, when the housing and mortgage markets overheated, then cracked wide open, taking the economy and stocks with them.

This time around, the biggest, unfettered bubble has been in bonds. That’s where assets still remain fundamentally mis-valued, and where I believe further price declines are the most likely.

So if you want to beat these burned funds at their own game, and maximize your returns, don’t join them when they’re maniacally running for the hills. Take advantage of short-term pricing gyrations caused by their need to pare back leverage, and add exposure in promising sectors and stocks.

Make sure you stay vigilant, as I am. If we see fundamental deterioration in the economy (outside of sectors like housing, which I flagged long ago as vulnerable to rising rates), then that would mean it’s time to get more defensive.

Until next time,

Mike