Last year, the HFRI 500 Fund Weighted Composite Index, which measures average hedge fund performance, fell by 4.25%, marking the worst decline since 2018. Equity-based hedge funds had it even worse, posting losses of 10.37%, which still beat the S&P 500’s loss of 19.4%.
Now, the hedge funds who carried their short positions into the new year are faced with a difficult dilemma. Year-to-date, the S&P 500 is up by about 9%. Long hedge funds have taken advantage of this, but those on the short side are facing a different fate.
Last week, hedge funds covered their short positions at the fastest rate since 2015. Short coverings were even greater than during the epic January 2021 squeeze of meme stock general GameStop (NYSE:GME).
Hedge Funds Rush to Cover Short Positions
The short covering was driven by a lower rise in interest rates compared to past hikes and the dovish tone of Chairman Jerome Powell. Following those events, companies like AMC Entertainment (NYSE:AMC), Carvana (NYSE:CVNA) and Bed Bath & Beyond (NASDAQ:BBBY) took off in price, despite questionable and precarious balance sheets.
A further rise in the markets would likely equate to even more intense short covering. That would lead to an uptick in price once the short sellers cover their positions by buying shares of the underlying stock.
According to Goldman Sachs, the largest short positions held by hedge funds fall within the information technology and industrials sector. The investment bank also noted funds sold out of many long emerging Asian countries and Chinese equities positions.
However, several Wall Street analysts have voiced their opinion that the recent uptick is just a bear market rally or trap, such as JPMorgan strategist Marko Kolanovic. Kolanovic expects two more rate hikes in March and May and then a period of stable rates. He adds consistently high wages could lower gross margins across the board, which could result in even more layoffs. As a result, the strategist recommends investors take advantage of the recent gains and sell out.
Morgan Stanley’s Mike Wilson has a similar viewpoint. He cites falling corporate profit estimates for 2023. As of the end of January, S&P 500 earnings per share growth estimates were negative, which has only happened five times since 2000. Prior instances occurred in 2001, 2008, 2015 and 2020. Wilson concluded the current earnings recession is not priced into the market, and investors should expect lower prices.
On the date of publication, Eddie Pan did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.