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.