JPMorgan Says Hedge Funds’ Short Covering May Have Further to Go

(Bloomberg) — Fueling the epic rally in US stocks last week, hedge funds were beating a fast retreat from big bearish positions.

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Now, with risk-on exposures still low, the unwinding of shorts may have room to run, according to JPMorgan Chase & Co., a move that would encourage other money managers to chase market gains.

When the S&P 500 surged more than 5% Thursday, hedge funds that make both bullish and bearish bets unwound short sales, with net leverage jumping the most since March 2020, data compiled by Morgan Stanley’s prime broker show.

At Goldman Sachs Group Inc., fund clients rushed to reduce shorts, particularly in macro products such as exchange-traded funds. Bearish positions in ETFs dropped 8.5% over the week through Thursday, marking the largest short covering since March 2021, according to the firm’s prime broker unit.

The data backs up the idea that bears who were compelled to fold may have helped propel the vicious market bounce following a cooler-than-expected inflation print. To JPMorgan’s team including John Schlegel, the episode resembles the start of what happened during July and August, when forced covering of short trades morphed into a genuine stock chase among a broad cohort of investors.

“Moves like this where the markets race higher and hedge funds are left behind tend to result in behavior akin to ‘chasing one’s tail,’” they wrote in a note to clients Friday. “Positioning was very low heading into the recent rally…but is still quite with short exposure high and not enough covering to say that’s done yet.”

The S&P 500 added 0.1% as of 12:43 p.m. in New York, erasing an earlier loss of as much as 0.7%.

During the two months through mid-August, the S&P 500 jumped 17%, while a Goldman basket of most-shorted stocks surged 45% over the stretch. This time, even after a two-day, 18% rally, the short basket has yet to inflict much pain over a longer timeframe. For instance, the group is still down for November and trails the market by almost 2 percentage points over the past month.

Any further upside is likely to force additional short covering that in turn adds fuel to the rally and prompts money managers to reconsider their bearish stance, according to Schlegel and his team. By their estimate, the accumulative short covering over past four weeks has yet to show an extreme deviation from the historic average.

Read more: Burned Shorts and Another Options Bash Fuel Massive S&P Bounce

Despite the latest short unwinding, the fast money’s equity exposure remains cautious. Broadly, hedge funds’ net leverage, a gauge of risk appetite that measures the industry’s long versus short positions, sat in the 24th percentile of a one-year range, Goldman data show.

The data highlight a key risk for defensively positioned money managers: A year-end rally that threatens annual performance, according to Scott Rubner, a Goldman managing director.

“There is NO FOMO (fear of missing out) from clients in the market, but there is FOMU (fear of materially underperforming) into year-end if we actually do rally,” he wrote in a note Friday. “Positioning is under exposed to a rally from here and the pain trade is higher.”

–With assistance from Melissa Karsh.