Hedge funds kick risk addiction at end of crazy year for stocks

CALM has finally come to a stock market that for weeks had been swinging violently. Bulls who hung tough are ending the year on firm footing after a frenzied off-loading of risk by professional speculators.

December's big sellers were hedge funds, which, chastened by wrong-way bets on high-flying software firms, spent the month slashing high-momentum trades. It helped make this one of the most volatile year-ends for big-cap tech in the past decade.

While a rally restored order in the S&P 500, doubts remain about the path of Omicron and how central banks will fight inflation. The bounce that took the index to an all-time high followed a period where cash was building and retail investors, the die-hards who once flocked to bullish options for quick profits, became worried about the downside.

"With risk having been significantly reduced and investors now looking past Omicron, there is now a lack of selling supply as momentum has changed," said Eric Johnston, head of equity derivatives & cross-asset products at Cantor Fitzgerald. Still, he reckons, the rally is apt to be short. "The bull market as we knew it, I think, is over," he said. "The liquidity drain from the system and overall tighter Fed policy will be a headwind for risk taking."

Surprisingly strong earnings and optimism about the economy powered the S&P 500 to almost 70 all-time highs this year, on course for the second-best annual tally ever. Signs that Omicron may not be as lethal as other virus strains clashed with steady news of business closures and travel restrictions around the world that threaten growth.

A newly hawkish Federal Reserve is also adding to the lack of conviction that characterised December. The S&P 500 has alternated between gains and losses every week.

Rising scepticism

For those who watched the S&P 500 double in 20 months and worried about bubble valuations, rising scepticism is perhaps a welcome development, putting the market on healthy footing.

To contrarians, all the caution suggests that doubters may have been washed out and a little bit of good news could trigger market gains. JPMorgan Chase & Co strategists led by Marko Kolanovic predicted a strong rally into the new year, as bears reverse positions.

Shunning risk now could be a mistake, says Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management. "It's too early to get bearish, to think the market is going down, because corporate fundamentals are going to continue to come in strong," he said in an interview on Bloomberg TV. "There will be opportunities to take advantage of what the market offers, but you have to be willing to go against the grain, and that means taking more risk right here today."

Despite last week's rebound, the risk-taking spirit has taken repeated lumps of late. While the S&P 500 has managed to post all-time highs in December, the pain below the surface is brutal.

Carnage in the riskiest corners dealt a particularly harsh blow to hedge funds who had piled into high-growth, high-valuation stocks, prompting a swift unwinding. Over the past few weeks, their net exposure in expensive technology shares and those that have yet to make money dropped by roughly 4 percentage points to about 14 per cent, the lowest level since mid-2020, according to data compiled by Morgan Stanley's prime broker.

The risk-off sentiment was echoed by Bank of America Corp's latest survey. In that poll, global money managers this month boosted their cash holdings to the highest level since May 2020 while trimming their stock exposure to a 13-month low. Among amateur investors, the once-raging gaming spirits are ebbing.

To be sure, belief persists. Recently, when the S&P 500 fell on several days, investors poured US$30 billion into exchange-traded funds focusing on US equities, the largest inflow since March. A closer look at stock performance revealed a clear preference for safety. Companies with stable income and dividends, such as utilities, health-care and consumer staples, have led December's leaderboard.

"Investor confidence is in somewhat short supply," said Nicholas Colas, co-founder of DataTrek Research. His firm just conducted a survey on the market outlook for 2022 and found the majority thought the S&P 500 would be up less than 10 per cent. BLOOMBERG