In the last five months, hedge funds that have been trailing the S&P 500 are cutting bearish bets at the fastest rate in two years and buying stocks.

An index that deciphers the bullishness of hedge funds saw a rise in the results to 48.6 last week.  That is up from 42 back at the end of November.  It also happens to be the largest increase in the index since April 2010.

Fund managers have been trying to erase last year’s losses with gains from the rally that we are in right now.  It is estimated that hedge fund buying frenzy is a reason that the S&P is up 27% since October.

However, have we reached a spot that is too far?  The rally has gained so much so fast that it almost seems dangerous to continue to hold stocks.  Bulls say that hedge funds buying combined with continued good economic reports should allow stocks to continue to rise.  Bears say that we have climbed too fast with not a lot of justification and that a correction is imminent.

In October of 2008, we were at a five year high in number of short bets that were in the market.  The rally has since been fueled by shorts repurchasing their shares.  For instance, Sears Holdings Corporation (NASDAQ:SHLD), has a 128% gain, the largest gain in the S&P 500, not because it is a good company but because there were so many shorts covering their position.

There are a few threats on the horizon.  Rising oil prices have the power to derail our recovery and put us straight back into a recession.  Dismal growth numbers are also a fear as 2012 progresses.  Investors are also increasingly more concerned with China and their slowing economy and of course Europe.  Despite these concerns, we have been lucky with good reports lately that have been suggesting that the labor market and housing markets are on the mend and finally beginning to recover.

As far as the rally goes, it is unwarranted.  There is nothing to truly justify the 27% increase in the S&P since October.  I believe we are heading for a correction rather quickly as more and more hedge funds will want to lock in gains for the beginning of the year to calm investors’ nerves.  In addition, if economic reports unexpectedly turn more bearish over the next month, we could see the beginning of a correction also.  It seems like we are always waiting to see when the correction will come and then it comes after you least expect it.