Anatomy of the correction: Net short in futures at all-time high In terms of fundamentals, following the relatively uninterrupted rally of 70% from the March lows, there was a growing consensus for a correction (-10%). In the event, the sequence of three shocks in quick succession (China tightening; Greece sovereign risk; and Washington policy risk) trumped much-better-than-expected Q4 earnings, resulting in a peak-to-trough 9% sell-off. We argued that the selldown was a temporary correction and an economic recovery was far from being priced into US equities (US Equity Strategy, What’s Working? February 10, 2010). In terms of flows and positioning, the sell-down saw notable outflows from mutual funds (1.4% of AUM); mutual funds and hedge funds reduced exposure to the market by 8 and 20 percentage points, respectively; and most notably, the S&P 500 net futures short position increased by ~60k contracts, to an all-time high. The latter short was bigger than last March, which saw the S&P fall 15% over the month ...
The team of sweet strategists forgot to mention that "the dumb" speculators were net short with large positions at the market top in 2007, and well into 2008. Click on chart to enlarge, courtesy of Deutsche Bank, my annotation with red ellipse.
And they continue with reasoning as follows:
The underweight positioning overhang remains Equity flows turned modestly positive over the last two weeks, but have further to recover in cumulative terms. Mutual fund positioning turned up from underweight to neutral. However, long-short equity hedge funds positioning remains more than 10 percentage points underweight relative to November-December levels and 15-20 pp below pre-financial crisis levels. Most importantly, the record net short S&P 500 futures position as of Tuesday last week had barely begun to be covered.
This, however, does not fit well with this puzzle of 3.6% cash by portfolio managers ... Did we send those bears already in retirement? But you know more about the risks now.
Look forward for this:
Our estimate of the implications of an unwinding of the net futures short position to average levels is S&P 500 upside to 1250. The key fundamental catalyst for the unwinding of positions remains, in our view, a recovery in the labor market. We expect March payrolls will be up a strong +350k (underlying recovery and a snowstorm snap-back) but the market will likely only get more confident with a second increase in payrolls in April.
Be careful! We are on a mission ...