Some Hedgies Just Outsmart Themselves

 | Jul 02, 2014 | 3:23 PM EDT
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When the number came out, you could imagine a collective cringe among all the hedge-fund geniuses out there. I'm talking about the Morningstar number that hit the tape yesterday, the one that showed $6.9 billion in outflows from domestic equity funds in May.

Why is this number so important? Because hedge funds typically aren't long-only. They almost always have shorts on, to be able to deal with the inevitable investors who come to these funds to make money in good times and bad. You don't get the extra 20% by just running around 100% long, especially when hedge-fund titan David Tepper, with $20 billion in assets, is telling another group of hedge-fund managers, "Don't be too freaking long right now," a mid-May utterance since retracted when the facts around the world changed to a more positive tilt.

You have to justify your franchise's existence, and a chief way to justify it is to bet against the great unwashed who always storm in to the market at the top. That's the time-honored hubris at work that we see and hear from so many of these overpaid professionals. Bet against the clamoring of the retail throngs as they ride this market ever higher.

But this Morningstar number said the opposite had already occurred. The mom-and-pops didn't buy into this current rally, they sold into it. That's right, the retail investor got fooled by poetry and rhyming: He did sell in May and go away. What a travesty. Yep, this rally has occurred without them, and waiting for them to blow out now, after this sign of capitulation, may be a sucker's game. They've already sold and aren't responsible for the run, so don't expect them to turn tail at the next win by ISIS or the borderland fracas in Ukraine.

Which brings up a real issue: What the heck did happen in May that made so many retail investors run?

I think the answer is pretty simple: Their stocks crashed. The highfliers, the momentum names, such as Amazon (AMZN) and Netflix (NFLX) and Twitter (TWTR) and Google (GOOGL), collapsed, leaving them empty-handed. Worse, they heard propagandist after propagandist say that this moment is like 2000, when the first stocks that rolled over, the big techs, then brought down the whole market.

Now, no matter what you tried to do, you couldn't defeat this canard. It didn't occur to the pundits that there is a natural collective process, where the IPOs dry up, the gunner hedge funds get margined out, and insiders reach levels where they don't want to dump stock, all of which occurred at the bottom, which was most likely the maximum point of capitulation. All anyone seemed to be able to chatter about was the nasty Nasdaq 2000 paradigm of glib retail buying followed by disaster, and the "get out now" jeremiads permeated almost every discussion.

It didn't seem to interest the negativists that the percentage of actual momentum stocks compared with the rest of the market bore no resemblance whatsoever to 2000. Back then, the momentum stocks sported market caps of hundreds of billions of dollars. This time around, all the momentum stocks added together couldn't equal the market caps of just Cisco Systems (CSCO), Microsoft (MSFT) and Intel (INTC) at the top 14 years ago.

So they got out when the getting was bad, not when it was good.

You can't shoot against people who have already been shot. They can't sell. They are gone.

Of course, since May, we've had some solid IPOs that have soared even after the opening trade: (JD), Arista Networks (ANET) and GoPros (GPRO). That's so different from the springtime. The secondaries seem to be a thing of the past. The holders now aren't shaken by ISIS or Ukraine.

Now, don't get too cocky. Soon the big IPOs will return, the insider selling will heat up, and the hedge funds who sat out the rally will be warning everyone again of an imminent collapse. Right now, though, it's not the long-only innocents who are going to capitulate; it's the short-selling pros who, alas, as we saw yesterday and the day before and the day before that, simply can't take the pain and are now buying to close out their wrong-headed positions. 

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