Hedge Funds Build Bearish Bets as Stock Market Rally Slows

As the stock market has soared to new highs, hedge funds are starting to, well, hedge, with the largest short position in two months.
Hedge funds, US stock market
With hedge funds increasing their short positions, is it time to worry about the stock market? | Image: Angela Weiss / AFP
  • The stock market rally has slowed in recent weeks.
  • While earnings season has been good, pulled guidance made it easy to beat low expectations.
  • Seasonal volatility around the upcoming election suggests more uncertainty ahead.

Last week, the S&P 500 became the last of the major indices to make new all-time highs. Now that that’s happened, professional money managers are betting that another pullback is in the cards.

Hedge Funds Starting to Hedge Against Today’s Insane Market

At the start of the market crash in March, hedge funds were largely heavily long the stock market with the use of options and futures. That flipped as the market crashed.

Since the March crash, hedge funds have been net short the market, even as stocks have recovered from the fastest bear market in history.

Hedge fund shorts
Hedge funds have started to increase their bearish bets on the stock market, even as the S&P 500 briefly joined the Nasdaq near all-time highs. | Source: Twitter

Now, they’re starting to increase their bearish bets, reaching their highest level in two months. While that sounds dire, it would take a tripling of current bearish bets to reach the peak fear seen in April. This trend may still be in its early stages.

So, what do hedge funds know that investors don’t?

The Case for a Pullback

Markets can always drop, but right now, there are a few strong reasons for another pullback into correction territory.

First, there’s earnings season. We’re just about wrapped up for the second quarter, and overall, it was tough.

While investors expected numbers to be down across the board compared to last year, expectations were so low that companies were able to beat forecasts handily.

Since market prices have recovered but earnings haven’t, that’s pushed up the S&P 500’s overall PE ratio to 23, a level usually seen right before big drops like the tech and housing bubbles.

Second, the presidential election is a mere 78 days away. With early voting and vote-by-mail options rising this year, ballots could start to be cast well before that deadline.

There’s usually some volatility ahead of elections, and recent elections have seen a rise in volatility.

Market volatility ahead of elections
Stocks have become increasingly sensitive to presidential elections, with a rise in volatility occurring at least a month out. | Source: Wall Street Journal

The 2016 election saw the stock market decline about 9% from its prior peak before election day. Hedge funds may simply be upping their bearish bets as they expect a few big down days to hit in the next few months.

The Case for Further Profits

That said, hedge funds are often short for a simple reason: They’re hedging. In other words, that’s what they’re designed to do. Having a short position can pay off handsomely if a market drop occurs.

Given the leverage a fund can use, it can have a short position while also still being long the market and profiting more on that side.

With massive monetary measures in place, and with a continued push for more fiscal stimulus, markets can continue to head much higher, even in the absence of a fundamental reason to do so.

Adding it all up, though, it’s clear the easy profits in the stock market have been made for 2020. Hedging may lose some money, but in a market decline, it may save a fortune.

Disclaimer: The opinions expressed in this article do not necessarily reflect the views of CCN.com and should not be considered investment or trading advice from CCN.com. The author holds no investment position in the above-mentioned securities.

Sam Bourgi edited this article for CCN.com. If you see a breach of our Code of Ethics or find a factual, spelling, or grammar error, please contact us.

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