Glorified S&P 500

In last week’s commentary, I wrote about US growth from a fundamental perspective and I also discussed what the markets were telling us about US growth over the next 3-6 months.

My conclusion was that US growth has been slowing and will continue to slow over the next 3 months. That said, I expect the spread between my US Slow Growth Index and the US High Growth Index to continue to widen in favor of assets that perform well during slow economic times.

In fact last week that spread widened by an additional 171 basis points as the Slow Growth Index gained 0.86% and the High Growth Index lost 0.85%. My recommendation for those investors who invest in US equities at a sector level is to favor sectors like utilities and REITS over sectors like technology, consumer discretionary and financials.

This week I’m going to discuss the positioning of the top 50 hedge funds and their potential impact on the markets moving forward. The hedge fund industry has gotten a bad rap - and some of that is deserved - and yet it feels as though the only type of attention that is paid to the industry is when negative events occur, like Madoff.

This attention is surprising to me simply because the hedge fund industry is a mere infant compared to the mutual fund industry. As of the end of the first quarter, hedge fund assets hit a new all-time high of $2.7 trillion.

To put this number in perspective, the mutual fund industry has approximately $26 trillion in assets under management. All of the data on the top 50 hedge funds I’m about to discuss can be found at Factset.com.

I was surprised by the data and I think you will be too.

The top 50 firms control approximately $700B in assets or approximately 25% of the total hedge fund industry. The top 50 holdings represent about $200B of the $700B in total assets or approximately 30% of the asset managed by the top 50 firms are invested in these top 50 stocks.

 

The Top-Down Approach

Let’s start at 30K feet and work our way down. The geographical allocation of these top 50 holdings is: 86% Unites States, 3% United Kingdom, 2% Canada, 1% Japan, 1% China, the remaining 7% is other countries with insignificant individual weightings.

Frankly, I was shocked by this allocation. I’m generally under the impression that the smartest people in a particular industry tend to migrate to where the compensation for their particular strengths is the highest. I also tend to think that the top 50 firms essentially have unlimited resources and access to unlimited intellectual capital.

That said, I couldn’t believe that the largest guys in the game have 86% of their equity exposure based in the US with the second largest allocation being a mere 3%.

Drilling down to the market cap level, there isn’t a lot of creativity here either. 65% of the equity allocation resides in large and megacap companies with market caps greater than $10B.

The upside of this is that the top firms only have 6% of their equity allocation in small caps or companies with market caps under $2B. US small caps have historically performed very poorly during periods of slowing economic growth.

 

Drill Baby Drill

Drilling down yet another level, let’s look at the sector breakdown of the top 50 holdings. The largest three allocations from a sector perspective totaling 52% of the equity allocations are: consumer discretionary, technology, and financials.

Huh?

Yep, the largest 50 firms with unlimited resources for research and intellectual capitals have invested half of their equity assets in the three sectors that perform the worst when US economic growth is slowing.

How does this happen?

That question is answered very easily when you look at the sector breakdown of the top 50 firms versus the sector breakdown of the S&P 500, the allocations are nearly identical.

There are two sectors where there is greater than a 2% deviation from the S&P’s allocation to a particular sector: consumer discretionary and consumer staples.

What’s more, hedge funds have allocated 8% more capital towards consumer discretionary than the S&P’s allocation to that sector.  That is by far the largest deviation and there isn’t a worse sector to be exposed to when US growth is slowing.

Case in point, so far this year, the consumer discretionary sector (XLY) is down 3.65% versus a return for the S&P 500 (SPY) of 1.94%.

Now let’s take a look at the last level, the individual stocks themselves. The top 3 stocks held by the largest firms based on dollars invested are: Apple (AAPL), Microsoft (MSFT) and Google (GOOG). The top firms have allocated approximately 17% of their equity allocation to the technology sector and these three companies are a decent chunk of that allocation.

This matters for several resaons. First, if growth in the US continues to slow, technology will be one of the worst performing sectors. Second, so far this year, the US technology sector is up almost 1%, so the shift away from this sector has yet to occur. Finally, what are the top 3 holdings in the XLK, which consists of approximately 30% of the entire exchange-traded fund? You got it, Apple (AAPL), Microsoft (MSFT) and Google (GOOG).

The point being that once the rest of the world sees what we’ve already been discussing since mid-January, watch out!

Those three stocks are held by over 20 of the top 50 hedge fund firms. In a similar fashion, the top firms have allocated 21% of their equity assets to the consumer discretionary sector. Not shocking that a number of the top holdings in the consumer discretionary ETF, XLY, are represented in the top 50 stock holdings of the largest firms.

And despite,the fact thatXLY is the worst performing US equity sector so far in 2014, the rotation away from XLY has yet to occur. XLY has declined 3.65% year to date and is just a little over 7% off its 52-week high which was hit in early March.

If and when those firms decide to reduce their exposure to these companies because economic growth is slowing, XLK and XLY, among others, are going to feel it. The time to get out of your XLK or XLY holding (or to go short certain sectors if that’s your thing) is not once the stampede for the door has begun, but prior to it.

 

Focus Markets Update

Our Trade Ideas gained 4.5% last week on the back of our 2 SHORT FXI trade ideas which each added 3.5% to their gains. We were forced to close both of our LONG GLD trade ideas as well as our only SHORT UUP idea. I’m switching to a NEUTRAL bias for GLD because I have become increasingly weary of GLD’s technical picture.

As for UUP, I still think the intermediate term direction for the US Dollar is lower, however, from a trading perspective, I wanted to lock in our gain on the trade idea and wait for a shortable bounce to re-initiate that idea when the reward-to-risk was skewed in our favor.