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%.

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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