Hedge funds, which resisted chasing gains in November, gave in last month, with their net flows turning “meaningfully positive,” according to prime-broker data compiled by JPMorgan. While the broad exposure has yet to reach extreme levels, the swift bullish pivot sparked caution among the team led by John Schlegel.

Of particular concern was the pace at which fund clients unwound their bearish wagers. The amount of short covering since late October was larger than any period since 2018, aside from the pandemic rebound in March 2020. Similar episodes tended to herald imminent weakness, with the S&P 500 falling an average 5% to a bottom in the following month, Schlegel and his colleagues found.  

At Goldman Sachs Group Inc., Tony Pasquariello also observed an explosion in optimism. On a scale of -10 to +10, he estimated that the fast money community’s equity exposure moved from -8 to +8 between October and December.

“While that certainly leaves plenty of room for imprecision, I’m confident in saying this: it’s really hard to see how the spec crowd can sustain the amount of firepower in January that was deployed in November and December,” Pasquariello, the firm’s head of hedge-fund coverage, wrote in a note.

Unhinged optimism played a role in a market rout that occurred, until Friday, in the absence of any major macroeconomic inputs. That suggests the selloff can be taken with a grain of salt. Three readings on consumer prices are scheduled before monetary officials convene in March in addition to fourth-quarter earnings reports from companies, often the occasion for updated guidance in the coming year.

As always, the path of profits remains paramount for equity investors. Analysts currently see an overall growth rate of almost 11% for the S&P 500, reflecting double-digit gains in health care, industrials, technology and communication-services companies. US large caps trade at 19.6 times those estimates, a high but not unheard-of valuation versus recent years.

“I actually think the technicals in the equity market are terrific,” Rick Rieder, chief investment officer of global fixed income at BlackRock Inc., said on Bloomberg TV. “There are some equities you could buy that are traded at three times cash flow, seven to 10 times earnings.”

Viewed through the lens of positioning, the picture arguably remains bearish. Tracking money supply and asset holdings across countries, JPMorgan’s model showed that investors from individuals to pensions and asset managers have seen cash holdings as a percentage of their total portfolios falling toward the lows at the end of 2021. While the dwindling cash pile is partly a function of a rally in stocks and bonds, it also indicates a drop in potential buying power, according to JPMorgan strategists including Nikolaos Panigirtzoglou. 

“Our indicators currently point to elevated equity and bond positioning,” they wrote in a note. “There is currently a very low liquidity cushion to propagate financial assets further, thus posing downside risk to both equities and bonds going forward.” 

This article was provided by Bloomberg News.

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