Hedge funds: Hedge funds kick risk addiction at end of crazy year for stocks

December’s big sellers were hedge funds, which, chastened by wrong-way bets on high-flying software firms, spent the month slashing high-momentum trades. It helped make this one of the most volatile year-ends for big-cap tech in the past decade, with the absolute size of close-to-close moves in the Nasdaq 100 clocking in around 1.4%.

While a three-day rally restored order in the S&P 500 now higher by 26% in 2021, doubts remain about the path of Omicron and how central banks will fight inflation. The bounce that took the index to an all-time high followed a period where cash was building and retail investors, the die-hards who once flocked to bullish options for quick profits, became worried about the downside.

“With risk having been significantly reduced and investors now looking past omicron, there is now a lack of selling supply as momentum has changed,” said Eric Johnston, head of equity derivatives & cross-asset products at Cantor Fitzgerald. Still, he reckons, the rally is apt to be short.

“The bull market as we knew it, I think, is over,” Johnston said. “The liquidity drain from the system and overall tighter Fed policy will be a headwind for risk taking.”

Surprisingly strong earnings and optimism about the economy powered the S&P 500 to almost 70 all-time highs this year, on course for the second-best annual tally ever.

Signs that Omicron may not be as lethal as other virus strains clashed with steady news of business closures and travel restrictions around the world that threaten growth.

A newly hawkish Federal Reserve is also adding to the lack of conviction that characterized December. The S&P 500 has alternated between gains and losses every week, each with moves exceeding 1%.

For those who watched the S&P 500 double in 20 months and worried about bubble valuations, rising skepticism is perhaps a welcome development, putting the market on healthy footing. To contrarians, all the caution suggests that doubters may have been washed out and a little bit of good news could trigger market gains. JPMorgan Chase & Co. thinks so. Strategists led by Marko Kolanovic predicted a strong rally into the new year, as bears reverse positions.

Shunning risk now could be a mistake, says Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management.

“It’s too early to get bearish, to think the market is going down, because corporate fundamentals are going to continue to come in strong,” Slimmon said in an interview with Kailey Leinz on Bloomberg TV. “There will be opportunities to take advantage of what the market offers, but you have to be willing to go against the grain, and that means taking more risk right here today.”