Uh-Oh: Hedge Fund Managers Are Super-Bullish – Often a Bad Sign

There’s a modern urban myth that hedge fund managers are a cabal of geniuses, each one like an abomination created in a lab by splicing together the genes of Gordon Gekko and Yoda. It turns out they’re only human, after all, and have the same emotional and psychological flaws we all do. As heartening as that may seem, it could be bad news for investors in the stock market.

Data released this week by Merrill Lynch show that hedge funds have a net 45% exposure to equities, by far the highest in more than six years. Sounds benign enough, even cheery, but this is where human frailty comes in. Indicators of investor sentiment are popular analytical tools because history has demonstrated that whenever extremes are reached in bullishness or bearishness, stocks tend to move the other way.

US Investor Sentiment, % Bullish Chart

US Investor Sentiment, % Bullish data by YCharts

It works when the attitudes being measured are of small investors, newsletter editors or, it seems, hedge fund managers. Whenever their net exposure has been above 35% since 2006, the stock market has either suffered a nearly immediate tradable decline (January 2010, April 2012) or else has made marginal further advances before plunging (the 2007 top, March 2011).

^SPX Chart

^SPX data by YCharts

Among stocks most heavily-owned by hedge funds are Microsoft (MSFT), Google (GOOG), Berkshire Hathaway (BRK.B), Johnson & Johnson (JNJ) and Wells Fargo (WFC).

Certainly not every sentiment indicator is flashing such a stark warning, and some suggest more fear than greed. As Carla Fried noted earlier this week on YCharts, fund investors have been shunning stocks and favoring bonds throughout the financial crisis and the recovery from it. Other measures, such as those compiled by the American Association of Individual Investors, however, suggest more optimism. But given that Merrill’s hedge fund indicator has been particularly accurate since the 2007 all-time high and that stocks have made significant progress for nearly four years, the hedge fund managers’ lack of concern seems like a good reason to have some of your own.

Conrad de Aenlle, a contributing editor at YCharts, has covered investment and personal-finance topics for more than 20 years, writing for The New York Times, International Herald Tribune, Los Angeles Times, Bloomberg News, Institutional Investor, MarketWatch and CBS MoneyWatch. He can be reached at editor@ycharts.com.

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