Bull Case on Oil Stocks Sees Hedge Funds Buy to Save Quarter

  • Their weighting in oil companies is lowest since at least 2008
  • Now pressure to add exposure after missing rally, says FBN

What happens when you turn so sour on an industry that you cut holdings to the lowest level in seven years -- and that industry rallies the most since 2011? According to one analyst, you buy.

That’s the theory of FBN Securities Inc.’s JC O’Hara, who says hedge funds own so few of the energy, commodity and industrial stocks leading the Standard & Poor 500’s Index this month that it’s ruining their returns. To get anywhere close to catching up before quarter-end, managers will need to start snapping up the same oil-related companies they spent last year cutting loose.

“Even if I’m 100 percent allocated to the market, not having exposure to energy, industrials and materials means I’m underperforming,” said O’Hara, the broker dealer’s chief market technician. “If the market is moving higher and if you have no allocation or a small weighting to those stocks responsible for most of the gains, you’d want a little skin in the game, or else there’s no way you could catch the S&P 500.”

The issue for anyone using the S&P 500 as a benchmark is how quickly leadership has changed in the space of a few months. While energy stocks in the gauge posted the worst return by far in 2015, falling 24 percent, they’ve been among the leaders of the rally that began when markets bottomed in February. Through Friday, oil companies advanced more than 16 percent, the biggest gain for any comparable period since 2011.

The upshot could be that the rally isn’t over, according to O’Hara, with purchases by hedge funds that feel forced to jump back in fueling the next leg as commodities prices from crude to gold and copper rebound.

Hedge funds certainly have room to pick up shares. In the last three quarters, they’ve lowered ownership of energy companies three times and cut materials and industrials twice, according to data compiled by Bloomberg from regulatory filings. Energy made up 6.1 percent of total holdings at the end of last year, the lowest percentage since at least 2008. The group may account for even less now, with UBS AG’s 2016 flow data showing hedge funds as net sellers of energy and industrials shares in the first 10 weeks of the year.

The divestiture shielded funds from bigger losses earlier in the year, when falling oil prices sent the S&P 500 tumbling 11 percent through Feb. 11. An index tracking hedge fund returns fell 8.4 percent during the same period.

Things have changed. Since the February low, the S&P 500 has recovered 11 percent versus the HFRX Equity Hedge Index’s 5.6 percent gain. Meanwhile, energy, financial and material shares have all gained more than 13 percent. 

After crude rallied more than 50 percent from a 12-year low last month and gold surged to levels last seen a year ago, managers may no longer have the luxury of skepticism on commodity-related stocks, said Don Steinbrugge, managing partner of hedge-funds adviser Agecroft Partners LLC.

“One factor is more the emotional: I’m getting in because I don’t want to miss this rally,” said Steinbrugge. “When you look at the hedge fund industry as a whole, part of allocation is looking in a rear-view mirror. Prices are moving up and there’s positive momentum, and it’s going to cause the industry as a whole to increase allocation.”

By the end of 2015, energy shares were among the three least-liked by the hedge fund industry, the first time they’ve rated so poorly since a 13 percent slide in the second quarter of 2010, data from Bank of America Corp. show. Yet in the back half of 2010, those same companies rose 36 percent, as hedge funds increased the percentage of holdings devoted to energy shares by 1.2 percentage points to 10.5 percent.

Unlike hedge funds, more traditional long-only managers have already started to buy up commodity-sensitive shares this year, said UBS equity strategist Julian Emanuel. There’s no guarantee that hedge funds will follow suit -- their consistent selling of those industries may mean that the bearishness will continue, according to Emanuel.

For long only managers, “this could represent the rebalancing of previously underweight exposure to these sectors,” wrote Emanuel in a note to clients Monday. Yet hedge fund “selling may signal the potential underperformance over the next few weeks.”

Energy shares in the S&P 500 fell 2.1 percent Wednesday after closing on March 18 at the highest level since Dec. 4. The benchmark gauge fell 0.7 percent to 2,023 at 9:37 a.m. in New York.

The approaching ends of the month and quarter increase the pressure on managers to touch up their holdings, said FBN’s O’Hara. Because the S&P 500 is positive in 2016 but most funds are still in the red, managers may want to clean up their books and more closely allocate to the benchmark before investors get a look, he said.

Even if manager’s don’t feel pressured, there are enough technical signals suggesting momentum behind the stocks that could put energy names on their radars, said O’Hara. For example, every industrial and energy stock in the S&P 500 is trading at about its 50-day moving average.

“Those are some levels that are pretty powerful, and most managers typically have some sort of momentum component to their stock screens,” O’Hara said. “When you start seeing energy, materials and industrials pick up on a momentum basis, you slowly start getting in when you’re very under exposed, otherwise there’s a drag. Those sectors are where all the winners are.”

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