Hedge Funds Bet Big on a Decline in Stocks, Pointing to a Rally
Stocks have been hovering near their lowest levels of the summer, struggling to get up off the deck. I suggested late last week that sentiment had turned sufficiently negative amid the market weakness and mounting evidence of a double-dip recession that a healthy rally might be due. Analysts at Citigroup (C) have reached the same conclusion after studying recent hedge fund activity.
In a note to the bank's clients, which seems to have been well timed, they highlight an extreme and sudden negative correlation between the returns of macro hedge funds (the type that make big bets wherever they see opportunities rather than specializing in certain niches, such as merger arbitrage) and the performance of the Standard & Poor's 500-stock index:
"The correlation between macro hedge fund returns and the S&P is the most negative in the history of the series [dating to 2003], indicating significant short risk positions [in stocks]. The only other time positions and returns have been [nearly] this negatively correlated was at the end of 2008 and early 2009 in the aftermath of the Lehman's crisis. Moreover the shift from extreme optimism to extreme pessimism is unprecedented in the history of the series. When correlations shift this rapidly it is possible that the flows are dominating the pricing rather than the new market information."
Translation: Hedge funds are overwhelmingly positioned for further declines in the stock market, and the sheer weight of their short selling, not fundamental developments related to earnings, interest rates or economic growth, seems to be responsible for much of the declines that have already been experienced.
The correlation of -0.8 between the funds' returns and the performance of the benchmark stock index shows not only that the funds are profiting from falling stocks but that they don't seem to be making any other significant bets. They apparently consider a bear market in stocks the best and only game in town.
(In case you think there may be something dodgy about Citi's data or the way they're analyzing it, here's a story confirming that hedge funds are shunning stocks and another showing that they're far from alone.)
The Citi analysts are cautioning anyone who might consider latching onto the hedge funds' coattails that the last time the funds thought that betting on a decline in stocks was something close to a sure thing was just before a massive rally. The market is not as oversold as it was in early 2009, but the preponderance of negative sentiment - and the money backing it up - is a good indication that a strong trading rally may begin soon, if it isn't already underway.
