As US markets set new records, hedge fund managers aren't buying the frenzy

The $4 trillion boom lifting equities for a month has been a YOLO feast, complete with spiraling meme stocks and surging options. For a slightly more staid group, hedge-fund managers, the frenzy has begun to sow skepticism.

The result is a market of contrasts, in which a virtually uninterrupted march higher in the major indexes has pushed volume in the day trader flier-of-choice, bullish call contracts, to some of the highest levels in history. Meanwhile, professional speculators -- many of them stung by upheaval in bond markets -- were going risk-off in stocks, cutting leverage at the fastest pace in months as many bearish bets backfired.

For both the celebratory and newly cautious, there are numbers to justify the view. The sheer force of the advance -- the Nasdaq 100 is up in 16 of the past 18 days -- is extremely rare, and missing out is costly. At the same time, similar runs have come in fraught years for equities -- 2007 and 1999, specifically -- suggesting to some that the time for prudence is at hand. 

“While I turned a bit more cautious at the start of the week, the trend remains your friend,” said Chris Weston, head of research at Pepperstone Financial Pty. “It becomes more of a FOMO trap into year-end.” 

Superlatives on the rally are piling up. Without a single down session, the Nasdaq 100 just scored two perfect weeks in a row, something that has happened only once before -- in 2017. That year also marked the last time when the gauge posted gains in all but two sessions over an 18-day stretch. On that count, the S&P 500 just notched its best run since 1990.  

Stocks rose for a fifth week for their longest rally in 14 months. After taking off amid robust third-quarter earnings, equities got a further boost from a string of dovish pivots from central banks. Federal Reserve Chair Jerome Powell said officials can be patient on raising interest rates and Bank of England kept rates on hold, upsetting bond bears. 

The options frenzy that was the signature of the pandemic rally in late 2020 is back. As traders piled in on speculative wagers for quick profits, daily trading in options averaged $538 billion last month, a record high, data compiled by Goldman Sachs Group Inc. show. 

The maniac momentum chasing was particularly acute in Tesla Inc., a stock that has soared more than 50% in a month. Last week, traders spent $51 billion on Tesla options. That’s almost half of the total premium paid for all single stocks, according to data compiled by Bank of America Corp. The firm’s strategists including Gonzalo Asis pointed to a spike in premium spent on small-lot calls as a sign that retail money may have helped drive the share rally. 

Alon Rosin, Oppenheimer & Co.’s head of institutional equity derivatives, had the first-hand experience with the retail euphoria. His older sister, who has never traded a stock, just asked about how to buy Tesla shares online. And that made him wonder how far this bull market can go.

“Is it time to pull the rip cord or is this what the market is trying to do in order to suck in every last dollar out?” said Rosin. These are the “things that make you go ‘hmmmm,’ but in the meantime, there is just too much speculation across asset classes that is working and FOMO is fully on here into the year-end chase.”

To say this year’s equity rally has surpassed expectations is an understatement. Up 25% to close near 4,700 on Friday, the S&P 500 was already 7% above the highest year-end target in a Bloomberg survey of Wall Street strategists that was conducted in January. 

The good news is all the price appreciation appears to have come from profit expansions. The bad news, despite a contraction in price-earnings ratios, stocks still look expensive relative to history. 

According to Leuthold Group that uses a five-year normalized earnings estimate to smooth out economic shocks like the pandemic, the S&P 500 ended October at 32.5 times profits, a multiple that before this year was seen only once before -- during the dot-com era. 

But valuation is never a great timing tool, a lesson that’s particularly worth heeding nowadays. When chasing winners is the only game in town, betting against stocks can be hazardous. 

A Goldman Sachs Group Inc. basket of the most-shorted shares jumped 12%, handing bears their worst week since the retail-fomented short squeeze in January, as Avis Budget Group Inc. and Bed Bath & Beyond Inc. soared.

That’s hurting the short book of hedge funds that have struggled to keep up with the market. Those tracked by Hedge Fund Research Inc. with a focus on equities have returned 12% this year, half the gain of the S&P 500. 

Amid a wrong-footed rally in meme stocks and the Fed’s policy update, hedge funds cut back their positions. Gross leverage, a measure of their risk appetite that takes into account both their long and short books, fell in each of the first three days of the week, with Tuesday seeing the biggest reduction since July, according to data from Goldman’s prime brokerage. 

Chris Senyek, chief investment strategist at Wolfe Research, sees a bubble forming in stocks, though he cautions about exiting too early now that major central banks have taken a more dovish tone in a coordinated fashion. Many money managers are likely to use the final two months as the last chance to catch up, he says.   

“Global central bankers recommit to the bubble,” Senyek said. “There’s probably a good bit of performance chasing going on as well. We see more upside from now to year-end.”