If investors ever needed a reminder that equity markets can suddenly change direction, then the past few days have provided a timely example.
The S&P 500 index, which hit a high towards the end of last month, fell almost 5 per cent this month, while the continent-wide Stoxx Europe 600 lost 4 per cent. US president Donald Trump's promise of further tariffs on Chinese imports, a slide in the renminbi that threatens to exacerbate the trade war and the Federal Reserve's perceived caution in cutting interest rates have all weighed on stocks.
The US equity bull market is now a decade old, raising reasonable concerns that we are nearing the end. Bulls, however, have found comfort in the belief that many potential buyers of equities are still not fully invested — cash still sits on the sidelines, waiting to buy at cheaper valuations if stocks take a tumble.
The argument has some merit. Fund managers' cash levels of 5.2 per cent are still above the long-term average of 4.6 per cent, according to the most recent Bank of America Merrill Lynch Global Fund Manager Survey, even if that figure fell from 5.6 per cent over the month in order for managers to buy risky assets such as stocks.
Bulls can also point to the fact that sell-offs, when they have occurred, have not proved long-lasting. Even the market slump of the fourth quarter last year was more than erased by this year's rally.
But hidden dangers for investors could be lurking in the form of the positioning of some computer-driven hedge funds. A key strategy for a group known as managed futures funds, which runs more than US$300 billion ($468.8b), according to data group HFR, is to latch on to trends in global markets. A long-lasting upward trend with low volatility, as seen in equities this year, is likely to attract bigger bullish positions.
As a note sent to clients by Morgan Stanley shows, these funds have been increasing leverage in the recent rally to close to the peak levels seen in January and September 2018. In both cases, sharp market falls followed.
If the market's trend moves from upwards to downwards, then these funds will cut their positions and start betting on lower prices. Their bullish positioning raises "the risks that a macro shock could activate forced selling from this community", warns Morgan Stanley.
"When there's a reversal that triggers CTAs [managed futures funds] to sell, there's likely to be a big gap lower in equities due to the average trend follower being extremely net long," said Robert Duggan, partner at SkyBridge Capital, which runs about US$9.6b in assets and invests in hedge funds.
Managed futures funds can quickly turn from buyers to short-sellers. Investors may find sell-offs can quickly gain a momentum of their own.
Written by: Laurence Fletcher
© Financial Times