The sheer size and prominence of hedge funds make their activity hard to ignore.
After Societe Generale’s latest dive into speculative bets, the conclusion was that funds have become too exuberant. In fact, the extent of their wagers across the equity, rates, and commodity markets “bear a worrying resemblance to the dotcom bubble,” according to a team of strategists including Arthur Van Slooten.
Investors have faced a dilemma: continue to chase the bull market in risk assets higher, or pullback and miss out on the final spurt of gains, they said in a note on Thursday.
“Positioning indicates that in many cases, investors appear to have capitulated.”
Here are some of the trades that suggest why:
‘Short volatility’ is back
No investor has forgotten the big blow up in February of the short-volatility trade. The CBOE’s volatility index, or VIX, spiked by the most ever in a single day on February 5, squeezing traders who had been profiting from the market’s calm in 2017.
But eight months later, hedge funds are now massive net sellers of volatility. In fact, their short-VIX positions are approaching historic levels, according to data from the Commodity Futures Trading Commission.
‘Uncomfortably high’ bets on stocks
The S&P 500 has recovered all of its losses from the recent volatility episode and is up 8.7% this year.
Hedge funds, on net, remain long the stock market, but their bets are “uncomfortably high” for Societe Generale.
The bank’s equity strategists have a 2019 year-end target of 2,200 for the index — about 25% below its current level — due to its valuation compared to less risky bonds.
Chasing oil higher
Hedge-fund exuberance doesn’t only exist in the stock market, according to Societe Generale’s strategists. They’re also flagging commodities, including oil.
Oil prices have ascended to four-year highs and hedge funds remain net buyers even though they’ve gradually trimmed long positions this year. But what’s concerning to Van Slooten and his colleagues is that hedge funds are short gold and the Swiss Franc — two classic safe-haven assets.
Societe Generale does not rule out a continued rise in oil prices, particularly as US sanctions on Iranian exports loom. But at the same time, the prevailing level of oil prices doesn’t strike the strategists as an attractive point to buy.
Historic bets against Treasurys
Hedge funds have made historic bets against 5- and 10-year Treasurys — positions they’ve built up all year long according to the CFTC’s data. Van Slooten believes the wagers have been underpinned by expectations for economic growth.
The big selloff in Treasurys this week pushed yields higher and provided some vindication for speculators. On Wednesday, the 10-year yield spiked by 12 basis points to its highest level since July 2011 following hawkish comments from the Federal Reserve chairman and strong US economic data.
“We strongly disagree with such a scenario” in which growth is robust and yields are rising, Van Slooten said. Societe Generale is less bullish than the consensus on US gross domestic product next year, forecasting just 1.6% growth versus 2.5%.
The strategists also appear to call hedge funds’ bluff on their bet against Treasurys. One imminent danger of this speculation, according to DoubleLine Funds’ Jeffrey Gundlach, is that if bonds rally, hedge funds could face a so-called short squeeze as they’re forced to close out their positions.
“With a US yield curve as flat as a pancake to begin with, and given the expectation of another Fed rate hike later this year, an inversion of the yield curve strikes us as a more likely scenario,” Van Slooten said.