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Rally Off 2009 Lows Flushes the Hedge Fund Shorts


Hedge funds top-ticked this market, couldn't defend 1400, and now are under water. Going into year end, you can bet the name of the game is liquidity. That means we could be encountering significant selling pressure.

MINYANVILLE ORIGINAL You heard a lot of silly excuses for last week's negative stock market price action that produced one of the worst weeks of the year. Obama was going to raise your capital gains taxes. The fiscal cliff wasn't going to get resolved. The pot-smoking commies had taken over the country. You had fire and brimstone, rivers turning into blood, mass hysteria with dogs and cats living together. For investors an Obama victory meant it was clearly time to panic. This was all a reactionary exercise in ex post analysis. Readers know that I have been mapping this move for weeks in an exercise of ex ante analysis.

My thesis ignored these issues and was predicated on what I believed to be the primary driver behind the price action: the positioning of hedge funds.

To understand the significance of their positioning you have to understand there has been a seminal change in the investment community over the past decade. Hedge funds used to generate alpha by betting against the crowd, but today they are the crowd, and they are betting against themselves. As an investor class, hedge funds had been short the entire rally since last year and were being forced to cover and eventually get long.

On August 13 in The VIX (INDEXCBOE:VIX) According to a 20-Year-Old Seinfeld Episode, I warned that investors were positioned for a repeat of August 2011 but that if we didn't crash the pressure was on to get long:
But after two weeks into August risk assets haven't crashed and now the market is at the post crisis highs, looking like it wants to break out despite decelerating economic and earnings growth. Investors are hearing it from both Costanza and Kramer and the uncertainty with whether they will get suckered yet again gets more intense the longer the market rally lasts. It is a dangerous time for all investors, retail and professional alike, but if this market remains bid into the Labor Day weekend, there will be tremendous pressure to get exposed to risk into year end.

On September 24 with the S&P (INDEXSP:.INX) having closed the prior week at 1460 only five points below the previous weekly closing cycle high at 1465, I wrote in Bond and Stock Market Volatility Is Collapsing Post-QE3:
QE III isn't causing risk assets to rise; it is simply the catalyst to bring in the last holdout market skeptics to finally capitulate and jump aboard the rally train.

I'm on the record as having been bullish for a long time. But when scared money gets long, I start to get cautious. The catalysts of extreme bearishness and skepticism that have been behind this rally are finally starting to wane. There could be more room to run, but we are in the late innings of this move and this is where it could start to get turbulent. Instead of subscribing to this QE III equals risk-on nonsense, I believe it's time to start playing defense.

Then two weeks later Bloomberg published its hedge fund index returns that showed Long Biased Equity HFs were up 5% for the month of September yet were still down on the year. It became evident that my thesis was playing out. On October 15 in Precipitous Drop Off in Demand for Money May Signal Repricing of Risk Assets, I noted this performance grab:
With a 5% gain on the month while remaining down on the year it's pretty clear to me that this performance grab has been largely responsible for the push to new highs. No doubt the underexposed speculative community has been pushing prices higher as they cover and get long. Also the consensus belief that QE3 will see a risk-on rally is an obvious display of confirmation bias and points to the fact that the market is long.

That week the CFTC's Committment of Traders report showed large speculators (aka hedge funds) to be net long 135,000 S&P 500 E-Mini (ES) contracts. With the exception of one week in 2011, this was the longest they had been since early 2010.
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