A question has arisen amid all the bank failures. How, with the bond market enduring its worst spasm of volatility in almost four decades, have benchmark-level stocks managed to glide along, oases of calm?
Part of the answer, as is often the case, is positioning.
Since the day before SVB Financial Group’s big share plunge, the S&P 500 is down only 1% despite a crash in regional lenders that has wiped out almost a quarter of the industry’s share value. The Nasdaq 100 has climbed almost 3% over the stretch, extending its year-to-date advance to 15%.
It’s a vivid example of resilience, particularly next to what’s occurred in Treasuries. While hopes for a pause in the Federal Reserve’s tightening campaign are also at play, big money mangers in equities have been on guard for the worst since before the financial fireworks erupted, cutting stock exposure while loading up on protection via cash and options hedging.
Net money flows for US stocks by hedge funds tracked by JPMorgan Chase & Co. have been turning negative since last August, according to the firm’s prime brokerage unit. Including other regions, net leverage among equity long-short funds now sits in the 6th percentile of its range since 2017 — a clear sign of risk aversion.
According to market-wide regulatory filings compiled by Goldman Sachs Group Inc., hedge fund holdings in banks stood 343 basis points below what would be indicated by a benchmark index at the start of 2023.
“At least some of this resilience is likely due to the selling that had been taking place prior to the past week and the somewhat low positioning,” JPMorgan’s team including John Schlegel wrote in a note Friday. “The overall picture from the US is one where there are many signs that flows have been quite risk-off, especially on a one-month basis.”
The peace contrasts with the turbulence in fixed income. As regulators stepped in to backstop depositors at lenders such as Silicon Valley Bank, bond traders rushed to scale back their expectations for Fed rate hikes in anticipation of tighter lending standards that would tip the economy into a recession. Short sellers who bet on higher policy rates were forced to unwind their positions, contributing to the biggest three-day drop in two-year Treasury yields since 1987.
Divergent positioning between fixed income and equity investors mostly explains why government bonds produced a more pronounced move in reaction to the banking chaos, according to Deutsche Bank AG strategists including Parag Thatte.
By the team’s tally, equity positioning from hedge funds to individual investors and mutual funds pointed to a defensive posture, with a measure sitting in the 18th percentile of a historic range. Meanwhile, bond exposure hovered near the lowest levels in more than a decade, leaving bears vulnerable to the risk-off rally as traders piled into bonds as havens from a possible recession.
“Bond positioning, on the back of recent data and supported by Fed speak, was extremely short and one-sided until last week,” the strategists wrote in a note Friday. “The banking shock then prompted massive short covering.”
The S&P 500 rose 0.9% Monday after UBS Group AG took over troubled Credit Suisse Group AG a day earlier and major central banks announced coordinated action to boost liquidity in US dollar swap arrangements.
While the equity market was more prone to big rallies on up days over and over in 2022 — in part thanks to defensive fund positioning that makes missing out on the upside the dominant fear among money managers — that dynamic hasn’t been in play this month.
Even with the subdued bank exposure, hedge funds tracked by Goldman weren’t taking their chances on financials. They quickly hit the sell button when bad news piled up. Last Tuesday, when Moody’s Investors Service downgraded its outlook for the US banking system to negative, the firm’s clients boosted bearish wagers on banks, with their long-short ratio falling the most on record and touching to an all-time low.
While exiting banks, they loaded up on technology shares, an industry seen as high quality with strong balance sheets. In other words, rather than bailing out of stocks entirely, some money is flowing to other areas of the market. And this type of rotation has helped the S&P 500 stay afloat in the face of the banking crisis.
From options traders to stock pickers, there was a sense of caution prevailing among equity investors before the eruption of the bank drama. Bank of America Corp.’s survey of money managers in February showed cash holdings stayed above 5%, while a net 31% of the respondents said they were underweight equities.
In the derivatives market, traders were geared up for more downside right before the bank crisis worsened. Open interest on calls betting on a rise in the Cboe Volatility Index — something that typically equates to wagering on equity losses — rose to the second-highest level since April 2019.
“A lot of it is coming from investors actually using options to express a bearish view on the market,” Alex Kosoglyadov, managing director of equity derivatives at Nomura Securities International, said in an interview last week.
All these bearishness means any bad news would have come as less of a surprise. In fact, considering the flurry of short sales that hedge funds have added in the past four weeks, JPMorgan’s Schlegel and his colleagues suggest more upside may be in store.
“Given how similar periods of large short additions have coincided with near-term market lows, there could be risk of an upside reversal once again,” they wrote.
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