Here’s a reason for the ongoing rally in the equity markets: Hedge funds have increased their gearing levels to the highest since March 2008. Their gearing went up from 1.16 in August to 1.39 in September, according to the Bank of America Merrill Lynch (BofA-ML) survey of fund managers for this month. The higher borrowing was perhaps the result of the fall in bond yields in the US.
Gearing is a higher level of borrowing to the owners’ capital.
Apart from increased hedge fund borrowing, the survey finds little change in the data compared with August. BofA-ML’s risk indicator is now at 37 against 39 last month. About 10% of asset allocators are overweight equities compared with 12% a month ago. There has, however, been an increase in the proportion of fund managers being overweight cash relative to their benchmarks—it’s now at 20%. Cash balances with fund managers have gone up from 3.8% to 4%. The BofA-ML buy signal for equities is when cash balances go up to 4.5%. Nevertheless, with a high cash overweight position, we still have some fuel for a rally. In February, before a short-lived bounce, cash balances were at 4%, a net 12% of investors were overweight cash and the proportion overweight equities was a net 33%.
The question is: Where will the money go? Sentiment on China bottomed out in August and a net 11% of investors now believe in stronger growth over the next 12 months. But the BofA-ML survey is treated as a contrarian signal, with too much optimism being a sell signal and the reverse for too much pessimism. By that yardstick, the Japanese market would be a screaming buy, with a net 32% being underweight that market, the lowest reading for nine months. Though emerging-market equities remained the favourite among investors, its overweight position has been reduced. A net 32% of investors are overweight emerging-market equities, compared with 38% a month ago. That leaves some room for emerging markets to rally. As for India, global emerging-market investors have a small underweight position, which again leaves some scope for more funds to come in.
There are a couple of red flags in the September survey. One is the increase in hedge fund leverage—a leveraged rally could fizzle out easily and will be more volatile. More importantly, it’s another sign of a return to the highly leveraged world before the crisis. Another signal is the curious finding that 60% of the respondents viewed the economy as already being in the mid-to-late cycle period. That, says BofA-ML, is an indication we’re living in a “warp speed economic world”. At least in India, that perception is consistent with the high valuations we’re seeing so early in the cycle.
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