Risky Wagers Cut Fastest in Two Years by Hedge Funds

Retailers and corporate America have been gripped by a buying frenzy, but big-money investors are shunning the rally. 

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Goldman Sachs Group Inc.'s prime brokerage has remained reluctant to chase market gains after hedge funds were forced to unwind bearish bets by last week's risk-on rotation. As the S&P 500 Index climbed for the fourth consecutive week through Thursday, investors trim their long positions.

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Stocks retreated by the largest amount since January 2021, when day traders notoriously banded together on Reddit to battle professional short sellers - a phenomenon known on Wall Street as de-grossing. 

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In addition to JPMorgan Chase & Co. data indicating professional investors have been cautious, Thursday marked the 10th-largest session for de-grossing since 2018. Combined with long activity, flow activity was "quite negative" during the last four weeks, according to the firm's prime brokerage. 

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As a hedge fund, you are known for your defensive investments — a strategy that helped you do better during the last year's selloff. However, your tentative positioning suggests that, with the Federal Reserve still tightening and corporate profits falling, the S&P 500's roughly 17% gain from October may have gone too far. Stock trading is above the meme-era peak amid corporate buybacks and a growing retail army, despite the lack of faith in the market. 

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Alpha Theory Advisors president Benjamin Dunn told me equity guys are shell-shocked and aren't acting like they normally do. There is a pretty uniform bearish sentiment on the sell side." 

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It was a surprise to hedge funds how strong the market shift was in the new year. This year, Goldman's indexes show that while their favorite longs surpassed the S&P 500 by 4 percentage points, their most-shorted stocks are outperforming by a staggering 17 percentage points. Overall, long-short equity funds have made 4.5% returns while their positions have appreciated by sheer price gains. 

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The stock market continued to retreat Monday after the strong jobs report released on Friday. The S&P 500 had already surpassed the average year-end target tracked by Trade Algo by 3.2% at its high of 4,180 last week.

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Despite Morgan Stanley and JPMorgan's warnings that the first half would be rough, hedge funds head into 2023 with low equity exposure and are unwinding short positions. Funds tracked by Goldman slashed bearish bets on technology shares amid the Nasdaq 100's best start in two decades, with short covering hitting the fastest rate in two years, according to their research. 

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Investors may have joined the party as a result of such covering, fueling the market rally. In January, Morgan Stanley's trading desk estimated that rules-based computer-driven funds purchased $95 billion to $100 billion of stocks, the highest buying since November 2019. 

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Net leverage, which measures hedge-fund risk appetite by weighing long and short positions, has risen over the course of the year, partly due to short covering. In spite of this, Goldman's data shows that it remains low at 69% for the first time in three years. A lack of euphoria was also observed among US managers in Morgan Stanley and JPMorgan fund exposure readings. 

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According to JPMorgan's team led by John Schlegel, there may be some residual de-grossing, but we might be at the end of the process rather than the beginning. Further, de-grossing/short covering often reverses as market rallies pull back from highs, and this may be another sign of a premature end for the rally."