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Hedge-Fund Leverage Rises to Most Since 2004 in New Year

Date: Monday, January 14, 2013
Author: Whitney Kisling, Bloomberg

Hedge funds are borrowing more to buy equities just as loans by New York Stock Exchange brokers reach the highest in four years, signs of increasing confidence after professional investors trailed the market since 2008.

Leverage among managers who speculate on rising and falling shares climbed to the highest level to start any year since at least 2004, according to data compiled by Morgan Stanley. Margin debt at NYSE firms rose in November to the most since February 2008, data from NYSE Euronext show.

Margin debt at NYSE firms rose in November to the most since February 2008, data from NYSE Euronext show. Photographer: Jin Lee/Bloomberg

The rising use of borrowed money shows that everyone from the biggest firms to individuals is willing to take more risks after missing the rewards of the bull market that began in 2009. While leverage means bigger losses should stocks decline, investors are betting that record earnings and valuations 9.8 percent below the six-decade average will help push the Standard & Poor’s 500 Index toward the record it set in October 2007.

“The first step of increasing risk is just going long, the second part of that is levering up in order to go longer,” James Dunigan, who helps oversee $112 billion as chief investment officer in Philadelphia for PNC Wealth Management, said in a Jan. 8 telephone interview. “Leverage increasing in the hedge-fund area suggests they’re now getting on board.”

The S&P 500 rose 0.4 percent to 1,472.05 last week on better-than-projected reports from Alcoa Inc. to Mosaic Co. (MOS) The index is about 6 percent away from the all-time high reached in October 2007 and has already gained 3.2 percent in 2013, led by Celgene (CELG) Corp. Futures on the S&P 500 advanced less than 0.1 percent at 8:24 a.m. in London today.

Stock Rally

Gross leverage, a measure of hedge fund borrowing that shows how much their holdings exceed the cash invested by clients, was 153 percent in the week ended Jan. 4, up from an average of 152 percent in 2012 and 143 percent a year ago, according to data from New York-based Morgan Stanley. The level has averaged 143 percent since 2005, the data show.

Managers are borrowing more amid a 15 percent rally in the S&P 500 since June, a gain that was mostly missed by professional investors who speculated shares would fall, according to data from Hedge Fund Research Inc. and International Strategy & Investment Group.

Borrowing increased as President Barack Obama and Republican lawmakers reached an agreement averting more than $600 billion in automatic tax increases and spending cuts.

‘Pretty Optimistic’

“We quickly added more leverage when results with the tax and debt issues were settled,” Timothy Ghriskey, the chief investment officer at Solaris Group LLC, which manages about $2 billion, said in a Jan. 9 telephone interview. “We’re pretty optimistic here on the equity markets as we move into the New Year. Valuations are extremely attractive and the earnings season looks good.”

U.S. equities have traded at an average 15.5 times reported earnings since the bull market started four years ago and were at 14.8 last week, data compiled by Bloomberg show. The S&P 500’s six-decade average is 16.4.

Hedge funds are borrowing at the same time they close bearish trades on American stocks that have made up a majority of their bets even after the market began to recover following the worst financial crisis since the Great Depression.

Individuals also fled equities during that period, withdrawing about $244 billion from U.S. mutual funds following the market rout that sent the S&P 500 index (SPX) to a 12-year low in March 2009, according to data from EPFR Global.

Gains Missed

Americans missed out on almost $200 billion of gains as they drained money from stocks in the past four years. Assets in equity mutual, exchange-traded and closed-end funds rose about 85 percent to $5.6 trillion since March 2009, trailing the S&P 500’s 94 percent surge, data through September compiled by Bloomberg and Morningstar Inc. show.

Confidence is only now starting to recover after daily volume on American exchanges last year slid to the lowest level since at least 2008. In the first week of 2013, $22 billion flowed into equity funds globally, the second-largest total in data going back to 1996, according to EPFR Global. U.S. equity funds took in $3.1 billion, the most since EPFR began tracking the group since 2000.

While leverage shows increased optimism, it multiplies losses when investors are wrong, according to Peter Sorrentino, who helps manage about $14.6 billion of assets at Huntington Asset Advisors in Cincinnati.

Slowing Earnings

“If you want to speed up a loss, put some leverage on it,” he said in a Jan. 9 phone interview. “There’s a fair amount of leverage being used at this juncture, maybe there’s a little too much optimism out there. It indicates investors are bullish, but if you look at the fundamentals, earnings growth has started to slow and it’s real tough to defend that.”

S&P 500 profits will increase 1 percent for the first three months of 2013, down from the 2.5 percent forecast for the fourth quarter, according to more than 10,000 analyst estimates compiled by Bloomberg.

Margin at NYSE firms, a measure of loans by brokers to finance equity purchases, increased for four straight months to $327 billion in November and was 22 percent higher than a year earlier. While the value of margin loans expands as stocks rise, borrowing has outpaced the benchmark’s gain by about 10 percentage points, data compiled by Bloomberg show.

Bets among hedge funds and other large speculators that S&P 500 futures will climb reached $10.3 billion at the beginning of January, close to a four-year high, according to data compiled by Bloomberg and the U.S. Commodity Futures Trading Commission.

Short Bets

Professional investors abandoned bets that stocks would decline last month, as the most-shorted shares staged the best rally in a year relative to the S&P 500. The 20 stocks with the highest short sales rose an average of 5.1 percent in December, compared with 0.7 percent for the full gauge, the widest gap since January 2012, according to data compiled by Bloomberg.

A gauge of hedge-fund bullishness, which measures how much they’re betting on rising shares, rose to 47.3 at the end of 2012 from 43.9 a year ago and is near the one-year high of 48.1 in August, according to a survey by Washington-based ISI. A reading below 50 still suggests a bias toward short bets.

About $9.3 trillion has been restored to the value of American equities since March 2009 as the S&P 500 climbed 118 percent, according to data compiled by Bloomberg. Over that period, the HFRX Equity Hedge Index has fallen short of the benchmark gauge for U.S. shares by an average of 10 percentage points a year, the data show.

‘Catch Up’

“Many managers are just behind their benchmarks and as a means to catch up they’re trying to utilize leverage,” Dan Veru, chief investment officer at Palisade Capital Management LLC in Fort Lee, New Jersey, said in a phone interview last week.

“You’ve got to earn your keep because you’re commanding a premium price for that underperformance,” said Veru, whose firm oversees $3.6 billion. “You’re underexposed to equities and you have to put your money to work quickly if you want to catch up.”

Professional investors aren’t the only ones growing more optimistic. Equity analysts have been boosting their price projections for companies in the S&P 500 so high that if they all reached their estimates, the index would be at 1,618.90, Bloomberg data show. The record is 1,565.15.

Fifteen Wall Street strategists tracked by Bloomberg on average say the index will gain 7.6 percent to 1,534 this year, while Laszlo Birinyi, president of Birinyi Associates Inc., says there’s a greater than 50 percent chance it surpasses the record in 2013.

‘More Acceptance’

“We’re still bullish,” Birinyi, who was among the first to advise buying stocks when the bull market began, said in a Dec. 20 phone interview. “What keeps things going forward is more acceptance when we start to see the individual come back somewhat, when we see people redoing their asset allocations.”

Hedge fund leverage has tended to rise and fall with the S&P 500. When the benchmark gauge for U.S. equities declined 19 percent in the five months through October 2011, managers cut leverage to less than 140 percent.

They boosted it as the S&P 500 gained 29 percent from that point through April, Morgan Stanley data show.

While growth has slowed, 2012 would still mark the third straight year of earnings expansion and 2013’s projected $110.40 a share would be a record, according to data compiled by Bloomberg. Of the 27 companies in the benchmark gauge that reported through last week, 22 have exceeded analyst projections.

Earnings Season

Earnings for all U.S. companies with a market value of more than $1 billion probably advanced to about $1.13 trillion in 2013, according to data and analyst estimates compiled by Bloomberg. That compares with $784 billion in 2007.

Alcoa (AA), the biggest U.S. aluminum producer, beat sales estimates after reporting a higher-than-projected average price for the commodity. Mosaic’s fiscal second-quarter profit topped forecasts after North American potash volumes exceeded its own prediction. The largest U.S. fertilizer producer has advanced 5.2 percent since reporting Jan. 4.

Celgene, the world’s fourth-largest biotechnology company, gained more than 22 percent since the start of the year after forecasting that earnings may exceed estimates in 2013.

While the U.S. is growing at a slower pace than its average since 1947, it will expand 2.8 percent next year, up from 2 percent in 2013, according to the median estimates of 96 economists compiled by Bloomberg. Unemployment has fallen to the lowest level since Obama took office in 2009 and U.S. pending home sales rose for three straight months, according to November data from the National Association of Realtors.

“Indicators are bullish and equity hedge funds are jumping on the bandwagon, thinking now is a good time to have more exposure to the market,” Anurag Bhardwaj, head of hedge fund consulting at Barclays Plc in New York, said in a phone interview. “That’s a good thing for the market overall.”