Popular media can be a very good source of market trends. Some recent things I’ve observed makes me think this long bull-market is coming close to an end.
I recently happened on a very interesting article that suggested that margin lending by hedge funds had reached an all-time high. It also suggested that hedge funds were generally exiting their short positions in favor of going long. While such indications may propel one last and final wave of exuberance in what is been a very lengthy bull-market, the increasing usage of leverage is also a precursor to the fact that the next leg down whenever that is will be a particularly nasty one.
According to the Goldman research, hedge fund leverage is at the highest it’s been in the market since 2009. Also interesting is that the short ratio as a percentage of total equity market value is also the lowest it’s been since the bull market began. While these two indicators can typically be viewed as near-term bullish for markets, taking a more contrary in perspective suggests that exuberance in the market is rapidly reaching a peak.
Successive waves of doubt and disbelief about the length and duration of the rally has now given way to FOMO or fear of missing out, with hedge funds giving up the fight and deciding that if you can’t beat them you have to join them. If you view hedge funds collectively as ‘the market’, high leverage and low levels of short activity suggests peak bullishness.
Also interesting was a distinct trend in chasing outperformance, with hedge funds collectively doubling down on Facebook, Amazon, AliBaba and Alphabet. Now, while all of these are companies of the highest quality, and all core members of Project $1M, the fact that new money is still pouring in here after these names are up 30- 40% in 2017 (or in BABA’s case over 100%) somewhat boggles the mind.
While I don’t believe the valuations on these businesses are onerous, seeing hedge funds collectively gearing up to invest in these businesses on mass doesn’t fill me with a lot of confidence. You can be sure that when the next cyclical downturn comes along that these names will be hit hard as the market corrects.
As a contra indicator, ‘peak exhuberance’ suggests to me that we are getting closer to the beginning of a market decline. Its the moment when something somewhere snaps in someone, and people step back and think, ‘what have we done’?. The tech decline in 2000 was just such a moment. However just because we may be at a moment of ‘peak exhuberance’, it doesn’t necessarily mean that markets will come down crashing imminently.
So what will trigger the inevitable decline? Short of a blackswan event, I see 2 potential triggers.
Rapidly rising interest rates trigger the next economic downturn. This is a little hard to predict in terms of timing and duration, but inevitably interest rates will be raised at a rate which sufficiently depresses economic activity causing an economic decline and a corresponding market decline. This will be a prolonged event that will play out over a couple of years.
We’ve run too far, too fast. A more concerning, and potentially far more rapid unwinding would take place if markets just woke up to themselves one day and say we have run too far, too fast. It may be as simple as the Fed and other Central Banks cautioning on excessive valuations or some other macro deleveraging event in some other part of the world (I see China as a possible cause) that results in the unwinding or liquidation positions. With gearing levels significantly up, these could facilitate an equally rapid tumble and decline that has been as rapid as the rise up.
While its not really possible to predict when and how declines will occur and what triggers them, what we can see empirical evidence of is indicators of optimism. Judging by the way hedge funds are behaving at the moment, I’d suggest peak optimism is not far from where we are. The contrarian in me, and the contrarian in you should be suitably concerned.
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