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Hedge funds rush back to stocks with leverage up the most since 2017

Investors are looking to raise exposure from below-average levels as the economy shows no signs of contraction

The spike in demand for borrowed money is the latest sign of improving sentiment after stocks suffered the worst December since the Great Depression.

New York

IF December was a crisis of confidence rivalling 2008 for professionals in the stock market, January has been a season of faith restored.

Hedge funds, initially leery of the equity bounce that has lifted the S&P 500 by 11 per cent, are showing signs of buying in as the rally endures. Their gross leverage, a measure of industry risk appetite, last week jumped the most since May 2017, client data compiled by Goldman Sachs Group Inc showed.

The spike in demand for borrowed money is the latest indication of improving sentiment after stocks suffered the worst December since the Great Depression. With the economy showing no signs of contraction and stocks on sale, investors are rushing to increase exposure from below-average levels, according to Jim Carney, founder of Parplus Partners.

"The market is going to go higher, that's what the signals tell me," he said in a telephone interview.

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There's more capacity for risk. While hedge funds making wagers both on and against stocks boosted their gross leverage by 6.8 percentage points to 233.1 per cent over the week through Jan 10, that trails the 12-month average by eight percentage points and compares with a peak of 252.4 per cent reached in February last year, Goldman data showed.

Hedge funds are part of a phalanx of money managers who are boosting risky bets as the S&P 500 rebounds in the new year, propelled by optimism over the Federal Reserve's monetary policy and positive US-China trade talks.

Henry McVey, head of global macro and asset allocation at KKR & Co, said in his 2019 outlook that the firm plans to raise holdings in US stocks because the sell-off since October reflected "a lot of bad news".

Jim McDonald, chief investment strategist at Northern Trust who turned cautious in October because of a more hawkish Fed, said he's advising clients to embrace risk by buying stocks in US and emerging markets at the expense of investment-grade bonds.

"The fourth-quarter sell-off in financial markets, alongside more dovish commentary from the Federal Reserve, has moved us off our neutral risk stance," Mr McDonald said in a video posting on the firm's website Monday. "We expect global resilience over 2019, which should result in good risk asset returns as recession risk is discounted."

Hedge funds had resisted embracing stocks at the initial stage of the bounce, with Goldman's measure of the industry's leverage falling to the lowest level in at least a year on Jan 3.

Similar data from JPMorgan painted a similar picture as the firm's clients continued to trim bullish bets during the post-Christmas rally through Jan 4 while raising bearish wagers.

Momentum shift

But the pressure for performance is building. Defying analyst calls that the S&P 500 would fail at the 2,600 resistance and then revisit its 2018 lows, the index instead topped that threshold Tuesday, extending its rally over the past three weeks to 11 per cent.

Meanwhile, the Hedge Fund Research HFRX Equity Hedge Index gained 4.8 per cent post-Christmas through Monday.

The S&P 500's one-month performance went positive for the first time since early December, a shift in momentum that may prompt trend-following quant funds to cover some of their bearish wagers, according to Charlie McElligott, a cross-asset strategist at Nomura Securities.

These funds, also known as commodity trading advisers, had held "max short" positions on stocks and a mere reduction to 82 per cent short would imply US$9 billion of buying in S&P 500 futures, his model showed.

"There is widespread under-positioning as catalyst for a rally," Mr McElligott said in a note to clients. "We still have yet to see the 'force-in'." BLOOMBERG

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