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
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.