Beware the Smart Money: Hedge Funds Issue Sell Signal

November 28, 2012   Stephen Taub

Hedge funds are piling into equities, according to one investment bank. The problem? When these funds get bullish en masse, the market heads south, new research shows.

As if the so-called fiscal cliff and the continuing European debt crisis weren’t enough for investors to worry about, a hedge fund indicator that so far has been foolproof suggests that the stock market is headed down for the next month — and very possibly for the next three months.

According to research from Bank of America Merrill Lynch’s Global Equity Strategy group, hedge fund net exposure to equities — their total long positions minus their total short positions, as a percentage of capital — is 40 percent. This is the highest this measure has registered in several years.

According to the bank, which looked at data going back to at least July 2007, whenever hedge fund exposure climbed above 35 percent during that period, the S&P 500 declined, on average, by 4 percent to 5 percent and lagged 10-year US Treasuries by nearly 7 percentage points over the subsequent four weeks. The stock market lagged Treasuries by 648 basis points, or 6.48 percentage points, over the subsequent three months. That is a big difference in such a relatively short period of time.

This is what you would call a contrarian indicator, since it suggests that the more positive hedge funds are on equities, the more likely the stock market will head down. While there have only been six previous "sell" signals since 2007, BofA Merrill’s research found that the hit rate has been 100 percent on both absolute terms and relative terms.

For example, after hedge funds’ collective exposure to the equity markets rose to 38 percent in October 2012, the S&P 500 fell 6 percent over the following month. During that same period 10-year Treasuries rose by 1 percent, according to BofA Merrill. In other words, stocks trailed Treasuries by 7 percentage points in just four weeks. After another sell signal, in April of this year, the S&P 500 lagged Treasuries by 4 percentage points, over both the ensuing one-month period and three-month period.

A similar pattern played out in February 2011 after hedge funds raised their equity exposure to 39 percent, the first time in more than three years they took exposure above the magic 35 percent level. The S&P 500 then declined 3 percent over the next month at the same time that 10-year Treasures rose 2 percent.

The most painful sell signals, however, came in 2007. After hedge funds’ equity exposure climbed to 40 percent in July of that year, the S&P 500 nearly corrected, falling 9 percent, while Treasuries rose 2 percent. You may recall that in mid-July of 2007, Bear Stearns sparked the market’s decline when it announced that two high-profile credit-oriented hedge funds it managed were nearly worthless. This was one of the earliest warning signs that the subprime mortgage market was starting to collapse.

Stocks quickly recovered after that, but only for a short time. In October 2007 the S&P fell 6 percent in the month after hedge fund equity exposure drifted back up to 37 percent and lagged Treasuries by 900 basis points. In the three-month period following the sell signal, the underperformance was 1600 basis points, or 16 percentage points.

So, what is the moral here? It may be that hedge fund money — the so-called smart money — is not as smart as it’s cracked up to be. This contrarian indicator is not so different from those that track individual investors. Many market pros like to say when individuals become more bullish or confident, it signals a market top.

Apparently, the same analysis applies to hedge funds.

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