Oct. 14 (Bloomberg) -- Hedge funds, whose bearish bets on stocks have held their returns to half the Standard & Poor’s 500 Index in 2013, pushed short sales close to the highest level of the year just as the U.S. budget impasse spurred a doubling in volatility.
Rising bets against equities sent a gauge of manager bullishness compiled by ISI Group LLC within 0.2 point of its lowest reading in 2013 last week. Short sales have backfired as the S&P 500, up 19 percent this year, posts one of its broadest rallies on record. The index gained 0.4 percent to 1,710.14, extending the biggest two-day rally since January as lawmakers struggled for an accord to raise the debt ceiling. It has swung an average of 0.82 percent a day in October, compared with 0.45 percent in the third quarter.
The embrace of bearish trades has squeezed returns for professionals and is one reason stocks have repeatedly rallied in 2013 amid slowing economic and profit growth, according to Cambiar Investors LLC and Pension Partners LLC. Rather than falling, shares that investors have shorted the most are up 38 percent since January, a consequence of forced buying during rallies by speculators who borrowed and sold them, data compiled by Goldman Sachs Group Inc. show.
“There still are people out there who are convinced the whole market and financial system is some house of cards,” said Brian Barish, president of Denver-based Cambiar Investors, which manages about $8 billion, said Oct. 10. “I think they wind up shooting themselves and their investors in the foot with the permabear mentality, but it persists.”
Senate leaders struggled to draft an accord over the weekend that averts a U.S. default and restores full government operations. Senate Majority Leader Harry Reid, who started talks with Minority Leader Mitch McConnell, said the two had “a productive conversation” yesterday. Democrats have warned that a lack of movement this weekend may have an effect on financial markets.
“We ended the week on a pretty upbeat note with relatively high expectations that a deal to end the government shutdown was pretty near,” Oliver Pursche, who helps manage $850 million as president of Gary Goldberg Financial Services in Suffern, New York, said by phone on Oct. 13. “By yesterday afternoon, it was pretty clear that there was still a lot of work to do. That’s a disappointment and you’re seeing that natural reaction from the market.”
The S&P 500 climbed 2.9 percent on Oct. 10 and 11 to 1,703.20, fewer than 25 points from its record on Sept. 18. Companies with the most short sales rose 3.5 percent in the two days and erased all losses since the U.S. government shutdown began Oct. 1, data from Bloomberg and Goldman Sachs show.
The ISI index of hedge fund long versus short bets fell to 48.4 in the week ending Oct. 9, from a 2013 high of 52.5 in March, data from the New York-based research firm show. Its lowest point this year was 48.2 in August. As ISI’s index decreases, it indicates managers are growing more bearish on equities. The measure dropped 4 percent in the last three weeks.
“As of Wednesday, hedge funds had turned cautious on the market amid the federal government shutdown and approaching debt ceiling,” Oscar Sloterbeck, senior managing director at ISI, said in an e-mail on Oct. 11. “While positioning does not appear extreme historically, the survey suggests there is buying power for equities if a deal is reached in Washington.”
The HFRI Equity Hedge Fund Index advanced 9.2 percent in the first nine months of 2013 and is poised to trail the S&P 500 for a fourth year, according to data compiled by Bloomberg. The gauge has gained about 48 percent since the rally started in March 2009, compared with 111 percent for the S&P 500. Hedge funds were closer to the S&P 500 during the last bull market, rising 85 percent from October 2002 through October 2007 as the S&P 500 jumped 90 percent.
The rally in 2013 has been the broadest in at least 23 years, as the Federal Reserve committed to unprecedented economic stimulus and stock valuations remained below historic averages. Of S&P 500 members, 445 are up so far in 2013, data compiled by Bloomberg show. The next-closest year was 1997, when 436 companies had advanced and the index was quadrupling.
Short ratios tracked by ISI are about the same as they were in August 2011, the last time the U.S. was threatened with a credit default due to a budgetary impasse in Congress. Bearish bets kept rising as the debate wore on and the S&P 500 slid almost 20 percent between May and October of that year. The benchmark gauge for U.S. equity has since rebounded 55 percent.
The measure of market exposure fell to a 2 1/2-year low of 42 on Nov. 23, 2011. The S&P 500 rallied 17 percent the following three months. ISI’s index, based on a survey of 36 mostly U.S. hedge funds with about $89 billion under management, tracks net exposure on a zero through 100 scale. Readings of zero show “maximum” short selling.
While hedge funds were squeezed the past four years after making bearish bets before the S&P 500 rallied, this time may prove profitable because growth prospects are lower and valuations are higher.
“The rising tide will no longer lift all boats,” said Peter Rup, the chief investment officer at New York-based Artemis Wealth Advisors LLC, which invests in hedge funds. “The really good equity long/short managers will outperform.”
Earnings growth for the S&P 500 slowed to 1.4 percent last quarter, according to analyst projections, after averaging 4.2 percent since the start of 2012. That’s a fraction of the 28 percent mean rate for 2010 and 2011, data compiled by Bloomberg show. At the same time, the index surpassed its record on March 28 and has rallied another 8.5 percent since then, pushing the price-earnings ratio to 16.3 from 14.1 at the start of the year.
“It is hard to be too critical of being more bearish going into the government shutdown and debt ceiling battle with the market up over 20 percent,” Howard Ward, the chief investment officer for growth equity at Rye, New York-based Gamco Investors Inc., which oversees about $40 billion, said Oct. 10. “We are not out of the woods yet, so those bets may yet prove worthy.”
Hedge funds have clung to shorts since they proved profitable in 2008. The ISI measure reached 41.5 in October of that year, the lowest since 2003, after Lehman Brothers Holdings Inc.’s bankruptcy spurred the worst crisis since the Great Depression and wiped out almost $11 trillion equity value.
CRC Income Products Short Only Fund, run by Brad Golding, more than doubled investors’ money in 2008, as the S&P 500 fell 37 percent, including dividends, data compiled by Bloomberg show. The Prudent Bear Fund, run by Doug Noland and Ryan Bend, returned 27 percent in 2008. Leuthold Group LLC’s Grizzly Short Fund, which is always 100 percent short, returned more than twice that.
Equity gains this year have pushed a Goldman Sachs index of the 50 most-shorted stocks in the Russell 3000 to rally 38 percent in 2013, almost twice the S&P 500’s 19 percent gain. Of the 20 S&P 500 companies with the greatest short interest, 15 of them posted gains last month, data compiled by Bloomberg show.
U.S. Steel Corp., the third-most shorted stock in the S&P 500, increased 15 percent in September, five times the benchmark equity gauge. The country’s biggest steelmaker by volume advanced another 6.7 percent so far in October, while the S&P 500 has rallied 1.3 percent.
Safeway Inc., the second-largest U.S. grocery-store chain, surged 24 percent last month. Short interest in Safeway was 19 percent of available shares, the sixth most among S&P 500 companies, data compiled by Bloomberg as of Aug. 30 show.
Short interest in Micron Technology Inc. was 10 percent of available shares on Aug. 30, data compiled by Bloomberg show. Shares of the largest U.S. maker of computer-memory chips are up 24 percent since then.
“This has been such a frustrating environment to express risk management in,” Michael Gayed, the chief investment strategist who helps oversee $250 million at New York-based Pension Partners, said in a phone interview. “The buy-the-dip mentality is so prevalent, so that with every minor drop there’s an expectation that there’s going to be a rip higher.”
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