Trader’s Narrative

Here’s an interesting chart from Merrill Lunch’s recent “Hedge Fund Monitor” report. It shows that traditional long short hedge funds have returned to a historically normal market exposure after the shock late last year:

With the end of the year barreling closer, hedge funds, like any other money manager out there wants to coast to an easy finish and hang on to their gains to be able to bank their lucrative incentive fees. One safe strategy is to sell their long positions and replace them with calls to have the best of both worlds.

This may explain one of the only places where we’re seeing some cautionary signs of exuberance. In last week’s sentiment overview I mentioned that the options pits is showing an awful lot of calls being bought relative to puts. While I’m hesitant to outright dismiss any irksome metric, some of that can be explained away by the penchant to lock in gains via calls. However, not all of it can be attributed to portfolio managers trying to coast to large Christmas bonus. That’s because the ISE sentiment which exclusively measures retail option traders is showing similar indications of exuberance.

Another interesting tidbit from the ML report is that hedge funds have on average reduced their exposure to ‘high quality’ stocks since April 2009. That makes sense since retreating into safer issues is a tried and true strategy in times of distress. Right now though, more speculative equities are getting most of the love. And that’s exactly what we’re seeing in the breadth measures as almost every single Nasdaq and NYSE stock participates in the rally.

You can download the whole Merrill Lynch report from the FREE trading resource section (check in the Reports & Articles folder).