Expert View: Let's play 'spot the joker' - the hedge fund version

"I'm buying drugs..." Raising an eyebrow, the waiter at the Savoy Grill dawdled a little. I went on: "With the risks in the market, I feel it's time for a touch of defensiveness in my portfolio." The hedge fund selector narrowed his eyes, and laid down his knife and fork. This has been a bloody fortnight for those at the riskier end of the market.

"I'm buying drugs..." Raising an eyebrow, the waiter at the Savoy Grill dawdled a little. I went on: "With the risks in the market, I feel it's time for a touch of defensiveness in my portfolio." The hedge fund selector narrowed his eyes, and laid down his knife and fork. This has been a bloody fortnight for those at the riskier end of the market.

Rumours swept London on 4 May that a "leading leveraged player" was in trouble. That player appeared to be dumping stock in smaller firms. Regus fell 12 per cent, Eidos 16 per cent, Regal Petroleum 18 per cent, Innovation Group 21 per cent. It was a panicked fire-sale. Then it was the turn of credit markets. While every bond analyst had predicted Standard & Poor's downgrading of Ford and General Motor's credit- worthiness, nervous selling took hold.

By the start of last week, markets were playing spot the joker - a game where traders tried to guess which hedge funds or investment banks were holding disastrous, hidden positions. This was made more fun by the rise of the complex instruments hedge funds love - the multi-layered credit contracts that look like astrophysics.

Share price movements in financial stocks were erratic last Tuesday. Deutsche Bank fell 3 per cent in Frankfurt, JP Morgan was down 2.3 per cent in New York and Man Group plummeted 4 per cent in London. Two leading hedge funds even had to issue letters of denial to their clients.

Get the picture? The market believes that somewhere out there are high rollers in trouble. No wonder my hedge fund selector was not touching his halibut.

Should we worry? Many of the young Turks slaving away at hedge funds may not recall Long Term Capital Management - it was way back in 1998. But at one point the crisis at that hedge fund threatened the whole banking system. It was damned close.

Now, it is true, most hedge fund operators are nowhere near the leverage of LTCM (28 times at the peak before its collapse). They prefer three to four times now, I'm told, although I'd like to check those figures. But it's worth recalling that, after 1998, the global economic climate could hardly have been better as the world's largest economy accelerated into the dot-com overdrive, and bailed out many of the riskier financial positions.

Now it's different - it's a bit chillier out there. The world economy is showing signs of pausing for breath. In the US, this means growth slowing to 3.1 per cent - hardly punishing, maybe - but in Europe it's starker. Thursday's eurozone GDP numbers were not encouraging - in Italy, the economy shrank (0.5 per cent) in the first quarter. In the UK, figures released last week showed retail sales down 4.7 per cent in April.

UK companies are also making downbeat noises. Abbey National announced on Tuesday that it would cut 4,000, rather than 3,000, jobs this year as the mortgage market weakened. After the problems at Kingfisher and Dixons, Jessops, the photo shop, reported a slump in sales on Tuesday, while Chrysalis, the radio company, warned that revenues would plummet.

The big danger is that this slowdown in consumer spending will overshoot and unsettle the housing market. Thankfully, the Government moved last week to close some of the more speculative buy-to-let schemes that are disrupting the market. Nevertheless, it was reported on Thursday that the price of new flats had fallen 17.2 per cent in the past year.

All economic cycles have a classic two-hump pattern. The first hump, the recovery from recession, is steep but soon runs out of steam. After a pause for breath, the second hump, the bull run proper, gets going.

The sudden chills at the end of spring are often a prelude to summer. Let's hope this is where we are. Meanwhile, why not go defensive? Buy drugs.

christopher.walker@tiscali.co.uk