With the Federal Reserve embarking on a tightening cycle and the war in Ukraine still upending markets, going defensive looked like a sensible move to many investors. Yet to their surprise, stocks rebounded right as the central bank raised interest rates for the first time since 2018.

Perhaps the gains owe to the Fed’s resolve to tackle runaway inflation, or to a realization that stocks tend to do well in the early stages of a hiking cycle. Whatever the reason, the S&P 500 rose in 10 of 11 sessions, staging one of the biggest advances in a decade.

The sudden rally was particularly painful for long/short hedge funds that failed to join the rally. In the final days of March, when retail investors rekindled dip buying in beaten-down names expensive tech stocks, the pros who had bet against these stocks in anticipation of higher rates were forced to cover their shorts, noted Goldman strategists led by David Kostin.

The same dynamic was seen on Morgan Stanley’s trading desk, where long/short hedge funds kept selling last week, while retail money and computer-driven traders rushed to scoop up shares.

“That demand is increasingly frustrating institutional investors, where U.S. L/S hedge funds sold longs and added to shorts,” Morgan Stanley wrote in a note. “March ended as one of the largest months of long selling from HFs in the last decade, and marked the second-worst Q/Q performance for U.S. L/S funds.”

Granted, all the caution can mean potential dry powder to further lift the market. Analysts at JPMorgan Chase & Co.’s prime broker observed that the recent pattern of hedge funds selling into the rally echoed those seen around the market’s troughs in December 2018 and March 2020.

In those episodes, net flows turned more positive starting about a month after the market lows, providing additional fuel to share gains. It wasn’t until fund positioning levels rose above above the historic average that the market saw a more meaningful pullback. 

The recent hedge fund selling into the stock bounce “may suggest, from a contrarian perspective, that equity markets could continue to grind higher,” JPMorgan analysts including John Schlegel wrote in a note. “That said, the macro backdrop is quite different from what it was in the prior episodes so it’s certainly possible that this time will prove different and the upcoming earnings season could be critical for determining the medium term trajectory of markets.”

--With assistance from Melissa Karsh.

This article was provided by Bloomberg News.

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