Hedge Funds Turn Bearish While Retail Investors Keep Buying Stocks

Hedge Funds Turn Bearish While Retail Investors Keep Buying Stocks 

A major indicator of potential downside risk in the stock market is when hedge funds begin shorting stocks while retail investors continue to pour money into equities. This is precisely the situation unfolding today.

The distinction between smart money and dumb money has long been a topic of discussion in financial markets. No one wants to be classified as the latter, yet retail investors are often labeled as such in contrast to institutional players and hedge funds, who are assumed to possess superior market insight. However, the reality is far more complex than these simplistic definitions suggest.

Despite facing numerous economic shocks such as policy changes, trade tariffs, and broader market disruptions, the stock market has managed to reach record highs. However, this does not mean the risks have disappeared. In fact, multiple factors, including declining excess liquidity, stretched valuations, and excessive investor exposure, are making further gains increasingly difficult to justify.

Until recently, hedge funds were aggressively participating in the market rally. Analysis of hedge fund strategies tracked by Hedge Fund Research (HFR) showed that none of the major categories had a negative correlation with the S&P 500, meaning these funds were positioned to benefit from rising stock prices. However, this trend has shifted over the past several weeks. A majority of hedge fund strategies are now exhibiting short exposure, signaling a growing pessimism among professional investors.

At the same time, some indicators suggest that retail sentiment is also turning more bearish. The American Association of Individual Investors (AAII) sentiment survey shows a rise in bearish sentiment relative to bullish sentiment. But in financial markets, as in everyday life, actions speak louder than words. Despite their stated concerns, retail investors are still aggressively buying stocks.

A closer look at fund flows reveals this contradiction. Data tracking annual investment flows into major exchange-traded funds (ETFs) such as VOO (which follows the S&P 500) and QQQ (which tracks the Nasdaq) indicates that retail investors continue to allocate significant capital to equities. For this analysis, SPY was excluded due to its heavy institutional use, as evidenced by the high trading volume of its short-term options.

This retail optimism is further supported by data from the Investment Company Institute (ICI), which reports that total equity flows into long-term mutual funds and ETFs have approached $200 billion over the past year. Meanwhile, hedge funds have significantly increased their short positions on individual stocks, a trend highlighted by data from Goldman Sachs.

While it is tempting to assume that hedge funds always know best, history shows that smart money does not always live up to its name, and dumb money is not necessarily foolish. Hedge funds, on average, have underperformed the broader market. Since 2020, the HFR Equity Hedge Index has trailed the S&P 500 by 55 percentage points, highlighting the limitations of blindly following professional investors.

However, when hedge funds turn bearish while retail investors remain bullish, historical data suggests that the stock market tends to struggle. During similar market setups in the past, the annualized return of the S&P 500 has dropped to 0%, a significant underperformance compared to the 10% average return from 2010 to the present.

Simply mirroring hedge fund positioning without considering retail sentiment is insufficient. Historical performance indicates that when hedge funds are short while retail sentiment is either neutral or aligned, the market still manages to deliver positive annualized returns of approximately 6.9%, reducing the degree of underperformance to -3.1%. However, when hedge funds take a bearish stance while retail investors remain overwhelmingly optimistic, the market tends to perform even worse.

Looking at past market movements, this pattern is evident in multiple stock market downturns since 2010, with the exception of the pandemic-driven collapse. During these periods, there were stretches where stock returns turned negative, reinforcing the idea that conflicting positioning between hedge funds and retail investors is a warning sign.

Conversely, when hedge funds take a long position while retail investors turn bearish, the market tends to outperform. The historical advantage, however, is relatively modest, with an outperformance of 4.8%, compared to the 10% loss seen when hedge funds are short and retail investors remain bullish.

Interestingly, when both hedge funds and retail investors are bearish, it does not necessarily mean the market will decline. This pattern has coincided with two major market recoveries: the rally following the 2018 sell-off and the rebound from the 2022 lows. It appears that strong rallies can emerge even when sentiment is highly negative, as investor fears linger after steep declines.

The coming weeks will reveal whether hedge funds' current pessimism is justified, but they do have several factors in their favor. First, excess liquidity, which has provided substantial market support, is rapidly diminishing. Second, stock valuations are at historically high levels, making further gains more difficult to sustain. Third, investor exposure to equities is at unprecedented levels across nearly all sectors except for corporate insiders, suggesting that most of the potential buying power has already been deployed.

Additionally, market correlation is at extreme lows, both in implied and realized terms. This presents a hidden risk, as periods of low correlation can lead to instability if and when trades based on dispersion strategies unwind. Low correlation has kept the VIX, a key measure of market volatility, suppressed. However, if volatility increases sharply, it could trigger a feedback loop where rising index volatility leads to increased market stress. A sudden shift in correlation could accelerate volatility spikes, similar to the turbulence observed in August of last year.

Another factor to consider is political uncertainty. While past policies have often been supportive of the stock market, there is no guarantee that this will continue. Many smaller, privately held businesses are currently struggling, and their owners and employees represent a significant voting bloc. Some policy shifts could prioritize economic restructuring over immediate stock market gains, introducing further uncertainty into the investment landscape.

While blindly following hedge fund positioning is not advisable, there are moments when professional investors may be signaling genuine risks. Today appears to be one of those moments, suggesting that investors should proceed with caution as hedge funds increase their bearish bets while retail investors continue to pour money into stocks.