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  • Hedge fund outflows have pressured stocks this year.
  • Quarter-end redemption letters this month contributed to the mid-month sell-off.
  • The S&P 500 is converging with key support levels, and redemption selling will abate as September progresses.

It's been tough for hedge fund managers caught offside this year. If they didn't sell stocks into the frothy market last year or reduce longs when the S&P 500 broke below the 200-day moving average in January or failed to hold it again in March, they got hammered.

In theory, that's not supposed to happen. But, in practice, it occurs during every bear market.

Hedge funds are supposed to offset risk by balancing long and short positions; however, they have wide latitude in how long or short they'll be at any moment. So if stocks are rallying, it pays to overweight the long side of their book, and buying big cap technology was the best way to do that in 2021. The technology sector represents about one-third of the S&P 500. Moreover, large-cap technology stocks, such as those comprising the F.A.A.N.G. acronym, are liquid enough to build and ostensibly reduce positions quickly. Their collective piling into F.A.A.N.G. (Facebook, Amazon, Apple, Netflix, and Google, err.. Alphabet) allowed them to juice returns and pocket-friendly inflows last year. Still, that overweight has come home to roost this year.

I regularly talk shop with Action Alerts PLUS co-Portfolio Manager Bob Lang. Yesterday, he suggested that one of the least discussed reasons for the recent sell-off was hedge funds' greatest enemy: quarterly redemption letters, which typically arrive 30-45 days before the close of a quarter. Given the market's swoon since mid-August, it could be an ugly quarter for redemptions.

In a chat with Real Money Pro's Doug Kass yesterday, he suggested it could be a very large quarter for redemptions. He wrote in his trading diary yesterday, "Redemption notifications for hedge funds normally require at least one-month notification…Hearing big redemptions out the last few days…Recent selling in anticipation could be accounting for the weakness of last few days."

Until recently, rock-bottom low-interest rates led many to opine there's no alternative to owning stocks (T.I.N.A.). However, GDP-busting interest rate hikes to quell inflation this year have changed that. Rather than accept the risk of loss, investors can shift to fixed income or, if risk averse, cash.

As Kass points out in his diary today, "the rise in interest rates represents a bonafide challenge that limits the upside to stock prices and valuations" because "The 1-Year U.S. Treasury yield has moved from an all-time low of 0.04% (14 months ago) up to 3.43% (today) - to the highest level since December 2007."

In short, there's an alternative now, prompting Kass to write, "Move over TINA, and say hello to my new friend TATA ("Treasuries Are The Alternative")."

With short-term Treasuries vying for assets and potentially driving outflows at hedge funds, quarterly redemptions could accelerate from an already concerning pace.

Hedge funds that Citco administers saw $10 billion in outflows in June. Eurekahedge pegs Q1 and Q2 hedge fund redemptions at $13.5 billion and $26.6 billion, respectively. This week, it said year-to-date global outflows total $84 billion, including $56 billion in Europe.

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Since redemption letters have likely been stacking up this month, putting managers on the hook to return the money once the calendar flips to October, they've probably been using strength from the mid-June rally to raise cash. After all, it's best to sell when you can rather than when you have to.

The selling could continue into September, but you could argue that at least short term, selling pressure eases.

Market volume typically improves in September because everybody's back from vacation, so remaining sell orders will represent a lower percentage of the total trading, giving them less "power" to move the market down. Also, while sentiment isn't as lousy as it was in mid-June – the last time redemptions were weighing down stocks – it's tilted negative again. The volatility index eclipsed 25, and the total put/call ratio was above 1.2 yesterday.

The deteriorating sentiment and the fact that the mid-August retreat has major indexes intersecting critical support could mean stocks are setting up for a short-term snapback rally, or as Kass' called it yesterday, a "snapper," surprising many.

The Smart Play

We may be in 'shooting distance' of a short-term relief rally. AAP's Lang wrote on August 29th that S&P 500 support is about 3950, and in a Twitter chat yesterday, Real Money Pro's Carley Garner said that 3900 is in play as support. That's only roughly 1-2% below where the S&P 500 is trading at the time of this writing.

If we break lower, it would be bad, but it could set up an even better buy point. Kass wrote yesterday that his trading range on the S&P 500 is 3800-3850 to 4200-4250. The lowest end of his range works out to -4.75% below current levels. That's not good news. However, a fall like that would also bring lousier sentiment figures, which could prove similarly bullish to June. If so, active investors who went short after our article on the 17th may want to start covering some profits, and those who paused buys may want to resume them, using stop losses to contain risk.

September is a notoriously terrible month. It's the worst month of the year, according to Stock Traders Almanac. Nevertheless, the first half of September is usually better than the second half of the month. Also, stocks have followed the average mid-term Election year analog nicely this year. Since 1950, the S&P 500's path in mid-term years has been for a low in late June, a retreat to a higher low in August, and an early September rally. It's anyone's guess if we continue following that path, but history often rhymes.

If you'd like to chat more, join me on Twitter. You can find me at @ebcapital.

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