Hedge funds shy away from betting against stocks

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Here's another piece of evidence that investors are growing complacent as the bull market approaches five-and-a-half years in age: Hedge funds are shying away from betting against stocks.

The loosely regulated funds have a number of unorthodox ways of making money, from betting on mergers and acquisitions, to using leverage for boosting gains, to buying distressed debt.

But betting against stocks using a method known as short-selling is a technique that arguably best defines what hedge funds do, giving them the opportunity to make money even when stock markets fall and hot stocks turn cold.

The problem today, though, is that other than a few brief setbacks, stocks have been enjoying a remarkably smooth ride for nearly three years, providing very little opportunity for making money through short-selling.

According to the Financial Times, drawing from research by Markit, hedge funds have been reducing their bearish bets to levels not seen since well before the collapse of Lehman Brothers in 2008, which ushered in the worst days of the financial crisis.

The research found that the percentage of outstanding shares in the S&P 500 that have been sold short stands at just 2 per cent, or the lowest level since Markit began collecting the data in 2006, the Times said. That's down from a high of 5.5 per cent.

The declining short-interest can be seen elsewhere, too. Within the European Stoxx 600 index, it is also just 2 per cent; in the U.K. FTSE All-Share index, it is less than 1 per cent.

You would think that near-record high stock markets would entice more, not less, short-selling. The S&P 500 has risen 190 per cent from its bear-market low in 2009 and even enthusiastic observers caution that stocks are slightly expensive relative to expected earnings.

What's more, the S&P 500 hasn't experienced a significant correction in about three years. That's an unusually long period of calm that is raising concerns among some observers that investors have grown complacent to the risks of a significant setback.

So why are hedge funds paring back on their bearish bets at a time when overvalued stocks are easy to find?

One possible explanation is simply that these investors believe stocks will continue to rally even higher on improvements in the global economy, rising earnings and ongoing central bank stimulus, making short-selling a painful exercise in a continuing bull market.

The Times pointed out that David Einhorn of Greenlight Capital said recently that it is "dangerous to short stocks that have disconnected from traditional valuation methods," meaning that it has become impossible to target stocks that are expensive relative to things like earnings.

Similarly, others have noted the possibility that stocks could be entering a "melt-up" phase – where stocks are carried substantially higher by momentum – driven by the monetary policies of the Federal Reserve.

But there's a contrarian argument to be made as well. Hedge funds have been struggling in an environment where investors can score big gains with little or no effort by buying low-cost funds that track major indexes.

According to Bloomberg News, hedge funds returned an average of just 7.4 per cent in 2013, trailing the S&P 500 by nearly 23 percentage points and marking the fifth straight year of underperformance. So-called long-short equity funds, which can bet on rising and falling stocks, performed only slightly better, rising 11 per cent.

This year, hedge funds have returned 3.2 per cent (to the end of June), according to Hedge Fund Research Inc., lagging the S&P 500's 6.2 per cent gain. Worse, funds that short stocks have lost 3.7 per cent. Since betting against stocks has been a difficult way to make money, it is little wonder that hedge funds are growing reluctant to run the risk of making a bad situation worse.

But if you are starting to wonder if the stock market is reflecting too much optimism, dwindling pessimism is another reason to be wary.