Stocks: Hedge Funds Winning Streak Indicates Caution!

The chart above shows monthly hedge fund performance from January 1996 to April 2010, thanks to the Hennessee Group LLC. As a contrarian indicator, the above chart shows that when hedge funds lose serious money and go through periods of forced liquidation, it tends to be close to or perfectly at an intermediate bottom of the S&P 500. Periods like these were seen during the LTCM crisis in 1998 when on average hedge funds lost over 7% in just three months; tech bubble burst during 2001 & 2002; and finally the crash of 2008, where hedge funds got completely slaughtered and were down almost 20% for the overall year.

On the other hand, when hedge funds enter periods of easy money through long periods of winning streaks (blue highlights in the chart above), tend to be an indication that the trade has become extreme overcrowded and majority are complacent. Just around the corner, market surprises to the downside, and usually in an abrupt and violent manner.

We have now entered one of these famous streaks seen in the last 15 years or so. Monthly hedge fund performance since August has been a perfect winning streak of return, which means eight months of solid returns without a dollar lost to the market. To be honest, the S&P 500 did move in a single line straight up, without a pause. These same managers are using low volatility (VIX @ 16) to leverage themselves up and try to increase returns. To say that we are once again entering a speculative bubble in equity markets might be an understatement, as the NYSE Margin Debt hits $320 billion in April and starts approaching those frothy 2007 levels.

Simple conclusions could be something along these lines... easy money, huge winning streaks, very low volatility and increasing leverage, usually does not equal strong future returns. It actually sounds to good to be true and eventually somebody will get hurt... very badly! Even tough retail investors are currently bearish, which could send the market higher by a margin or two, I would still stay very cautious as we could see some nasty surprises around the corner.