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- Bank of America strategists Savita Subramanian and Jill Carey Hall say hedge funds have dropped their defensive stance to bet on the US economy’s rebound.
- The stocks that hedge funds favor the most have prospered in 2020, a break from the historic pattern.
- Carey Hall names nine groups of cyclical companies that offer more potential gains because of their price momentum, earnings revisions, and valuations.
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After months of carefully playing defense, the world’s biggest investors are finally comfortable betting on the US economy again.
Not surprisingly, hedge funds did not want part of anything exposed to the US economy when that economy was being hammered by the COVID-19 pandemic. They wanted shelter from the storm. But as the recovery has played out, Bank of America Head of US Equity & Quantitative Strategy Savita Subramanian says they’ve adjusted.
“Hedge funds, which hit the lowest levels of cyclical versus defensive exposure in April of this year, neutralized this bias to equal exposure to both cohorts,” she wrote in a note to clients.
She illustrates that point with this chart, which shows hedge funds dramatically underweighting stocks in cyclical parts of the market compared to defensive stocks early this year as the downturn set in — and then snapping back to normal by the beginning of August.
More specifically, she says, long-only funds — the ones betting on stocks — have made big increases in their real estate and consumer discretionary holdings while selling defensive utility companies. They’re not all-in on cyclical sectors, though, as they’ve also reduced their exposure to banks and energy and industrial companies.
“Most of these sector shifts have served fund managers well,” Subramanian wrote. “The ten most overweight stocks outperformed the most underweight stocks by 19.2% YTD, the highest spread in a decade — where in most years, crowded stocks have lagged their neglected peers.”
Subramanian’s colleague, US equity strategist Jill Carey Hall, says that’s only the latest sign that economically exposed stocks are looking more appealing.
“In tandem with hedge funds closing their defensive vs. cyclical bias this past month (where we have found that HF positioning changes have been positive indicators), our tactical quantitative work has grown increasingly positive on cyclicals,” she wrote.
Carey Hall says that she’s identified nine areas of particular opportunity, scoring them based on a combination of price momentum, positive earnings revisions, and favorable valuations.
She says the most attractive sub-industry is household durables stocks, which have the strongest momentum and earnings trends and better-than-average valuations. Those companies include homebuilders like D.R. Horton and companies that make long-lasting household goods like Garmin.
HOW TO INVEST: In addition to buying the stocks individually, traders can get access to Carey Hall’s consumer-related themes using ETFs like the iShares US Home Construction ETF or a broader fund such as the Vanguard Consumer Discretionary Index Fund, which would include most household durables companies.
While she’s evaluating US companies, investors can get global exposure to automaker trends with funds like the First Trust Nasdaq Global Auto Index, while those who want a longer-term and more tech-oriented bet can try a fund like the Global X Autonomous & Electric Vehicles ETF.
Further down Carey Hall’s rankings come metals and mining companies like Newport Mining, companies that sell industrial equipment, including Fastenal, interactive media and services names such as Facebook and Alphabet, and general merchandise distributors like Genuine Parts.
She adds that media companies like Comcast and Charter have fairly high valuations but good price and earnings data, while semiconductor companies and chip equipment makers like Applied Materials and AMD have excellent price momentum, and slightly less favorable scores in the other two metrics.
Finally, general retailers like Dollar General have good earnings trends but don’t rank as high in valuation or price terms.
Carey Hall also advises investors to watch out for value traps, a group of industries that have favorable earnings revisions but lack price and valuation momentum, which could consign them to frustrating returns.
She says the biggest traps today are in healthcare technology, diversified telecom, communications equipment, diversified consumer services, industrial conglomerates, equity REITs, real estate management, and broad-based utilities.
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