Hedge Fund Capitulation?

Do you want to be right, or do you want to make money?

That, in a nutshell, is the quandry facing hedge fund managers this year. They feasted on the short side for the past three years. Mr. Market gave them 4 significant rallies to short, with each followed by a brutal sell off, leading to new lows all 4 times.

But the 5th rally was not the charm. Starting from a higher low, and taking the market to a higher high, the short side has gotten slaughtered since the March 12 reversal. Although this rally may be getting long in the tooth, the market internals are much, much better than the prior air pockets. Iraq, at least as a media war, is behind us; the President’s tax package passed; the economy seems to be gradually improving. Worst of all for the bears, the long term downtrend has been broken.

All this raises an interesting question: Is the present rally merely due to short funds finally repenting their Bearish ways, and going long? That’s the thesis WSJ’s Greg Zuckerman poses in today’s “Ahead of the Tape” column:

It’s one of the big secrets behind the market’s recent climb: Hedge-fund managers are throwing in the towel. For much of this year, managers of large hedge funds, especially those specializing in tech stocks, have been bearish. Rising profits? The hedgies dismissed them as nothing more than the results of cost cutting, and a boost from a lower dollar. Even improved earnings prospects surely didn’t justify those soaring stock prices, the bears said. Due to this stance, the average hedge fund is up just 9% this year, compared with the 43% gain for the tech-heavy Nasdaq.

Now, trying to stage a late-year comeback, some hedge funds are covering their short positions, or buying back stock they had borrowed and sold. (Hedge funds are investment pools that often use leverage and sell stocks short hoping they’ll fall.) Others have begun to load up on tech shares. A survey from International Strategy & Investment, a research firm, shows hedge-fund managers are as bullish on the market as they have been at any time in the past year. Overall, short interest on Nasdaq has fallen to its lowest level since May.

Does this mean the market has clear sailing ahead? Perhaps not: “Many of the savviest hedge-fund managers are convinced stocks are overpriced.” Some of the best known bears turned cautious and covered their shorts, just before the war began. That was a prudent and prescient move. But they never transmogrified into full blown bulls, and some got short again over the summer.

So why buy, if you think stocks are too pricey? It’s a question of bearing the pain. Shorting theoretically exposes you to infinite losses; in reality, if your positions as a short manager move far enough against you, your fund can be totally wiped out. So to just stay in business, hedge fund managers must take off bets that could destroy their hedge funds.

As the WSJ notes, “That’s not a ringing endorsement of the market, ” notes the WSJ. Might these “worrywarts” being missing a secular turn in tech spending? Perhaps, but as the journal states, the “upturn doesn’t justify sky-high prices for many tech stocks.”

While we agree, and believe a consolidation is over due (see Arms Index chart, nearby), there’s no advantage in fighting the tape. The market trend remains upwards.

Chart of the Week
Arms Index moving into territory suggestive of a minor, short term pullback. Indeed, after the almost V-ish move up, a little back-and-filling might be healthy at this point.

10 day moving average Arms Index
Arms Index.gif
Source: RedTechResearch

As long as internals do not decay too much, expect mild profit taking and consolidation. Every pullback has been met with under-invested bulls buying the dip. There’s no reason to think that any new retracement will be different.

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Quote of the day: “I don’t know how speculation got such a bad name, since I know of no forward leap which was not fathered by speculation.
John Steinbeck

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