Is the End of The Bull Market Near?

May 28, 2017

By Aaron Hankin

Prior stock market crashes saw hedge fund portfolios skewed to a small sector of stocks. Market concentration propped up overall stocks, and once they cracked so did the entire market.

Sir John Templeton once said, “bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Knowing where we are on the spectrum is the eternal question for investors. Signs a bull market is over has varied from peak to peak, from the housing bubble and subprime mortgage crisis of 2007-08 to the tech bubble on the late 1990s.

However, one constant preceding each crisis has been hedge fund positioning: they were overbought in tech stocks during the 90s bubble and bank stocks before the financial crisis. A recent Goldman Sachs report on hedge funds shows market positioning is showing some similarities in 2017. Hedgies are betting bigger on a smaller number of stocks while at the same time reducing shorts and other tools used to hedge these bets.

Diversification (or Lack Thereof)

Prior stock market crashes saw hedge fund portfolios skewed to a small sector of stocks. Market concentration propped up overall stocks, and once they cracked so did the entire market.

Today, hedge funds are holding more equities but over a fewer number of stocks. The much talked about FANG or FAANG (to include Apple) stocks dominate the Goldman Sachs VIP Index with four of them filling the top six spots. Three of them – Facebook Inc, Apple Inc and Amazon Inc – accounted for one-third of the S&P 500 year-to-date gains as of April 17. “Although portfolio density fell modestly in 1Q, hedge fund returns continue to depend on the performance of a few key stocks,” Goldman Sachs said.

“The typical hedge fund has 67% of its long-equity assets invested in its 10 largest positions.”

In March, John Hussman noted just how reliant the current market rally is on a few stocks, pointing out that as of March 13 more than one-third of stocks are already below their 200-day moving averages and more NYSE-traded stocks made new 52-week lows than new highs the week prior. On March 13, the S&P 500 closed at 2373, just 1.1 percent from its all-time high.

ETF Positioning

ETFs made up 2.3 percent of long portfolios in the first quarter of 2017, down from 3 percent in 2016 and now less than half its 2009 highs. While trimming ETFs might sound like risk reduction, for hedge funds it’s the opposite. “Hedge funds use ETFs more as hedging tools than as directional investment vehicles. The $106 billion of short ETF positions accounts for 78% of hedge fund gross ETF exposure,” Goldman Sachs said.

Coupled with this, hedge fund short interest as a percentage of the S&P 500 is at a five-year low of 1.9 percent.

Increasing Leverage

Hedge funds use leverage to borrow and increase the size of their bet on certain assets, and with the reduction in hedging vehicles, it looks like hedge funds are doubling down on their long bets. Should the market show any weakness, a potential sell-off will be deeper as they all head for the exits at one time.

Calling an equity market peak is something many have tried and failed, as no market is ever the same. However, there are certain characteristics of how hedge funds are positioned that suggest they are putting too many eggs in one basket, and even if they are the smartest people in the room, everyone suffers irrational exuberance when times are good.