Value Hedge Funds Biding Their Time As Calling A Top Gets Trickier

Any time the markets have been soaring up, up, and away, it’s only a matter of time before the tides will turn. Value hedge funds have been struggling as momentum and growth dominated the day, but we’re finally starting to see signs of change.

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HOT Q2 hedge fund letters, conference, scoops etc

Multiple hedge funds have written in their second-quarter letters about how the markets were doing the opposite of what they would normally do in times such as these. They've been lying in wait for the stock market to finally register the ongoing macroeconomic conditions, but so far, many funds have been having a difficult time calling the top, and for good reason.

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Value hedge funds are turning on tech

There's a growing chorus of voices sounding the alarm about volatility now, which is quite a shift from earlier this year when the song was higher and higher with no end in sight. Morgan Stanley strategists are among those warning that the market may finally be close to a top. Then again, it looked like U.S. stocks were at a top in January, but that turned out to be only a temporary setback.

This time could be different though, according to the firm, which is emphasizing a rotation into defensive investments and calling for the tech ship to begin sinking. Active portfolio managers began dialing down their positioning in tech and the longtime favorite FANG stocks last month, so Morgan Stanley is clearly not the first to posit a turn in tech right now.

Tides turning on momentum stocks

The million-dollar question right now is when momentum will finally lose its edge, and the firm's analysts feel it could happen any time right now. In fact, they suggest momentum is now suffering from two broken legs. Looking at a "sector neutral index of 12-month long short momentum," they expressed concern that momentum has broken down on both the long and short side.

The first downward leg came as defensives finally started to outperform after a long period of underperformance, and the Morgan Stanley team sees defensives as the short side of the momentum. The second downward leg occurred when tech and growth stocks weakened, pulling down the long side of the picture.

It's now looking like that weakening was only temporary, as many big tech names are right back to setting new record highs. Nonetheless, Morgan Stanley analysts warn that the extreme growth rates we've been seeing in earnings can't go on forever, and they're predicting that year-over-year earnings growth will peak in the current quarter.

Why the bears may have it wrong

As a growing number of value hedge funds and many well-known names in the industry keep trying to call a top, there are still a few who see plenty of room for growth. Strategists at LPL Research offered up some interesting numbers which could explain why it seems like the top everyone expects isn't coming.

Usually, the adage "sell in May and go away" holds true, but it didn't this year. According to LPL, history tells us that whenever the markets have ignored that trend, the rest of the year is usually very strong, especially when the S&P 500 is up in April, May, June and July, like it was this year. In each of the last 10 times this has happened, the year's last five months ended up bringing further gains.