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Hedge funds gird for U.S. stock sell-off

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U.S. stocks have piled up $1.5-trillion (U.S.) in market value this year, but hedge funds are bracing for tough times ahead.

Based on buying and selling in 2017, managers have stopped loading up on bullish positioning. They've also become less reliant on U.S. stocks by selling economically sensitive bank shares and materials such as copper, data compiled by Credit Suisse Group AG show. What are they buying? Gold.

It's a shift from late December, when hedge-fund exposure to U.S. stocks, particularly financials, reached near record levels.

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In part, the move is as simple as prudent management, with funds taking profit after the longest rally in banking shares since 2013, said Benjamin Dunn, president of Alpha Theory LLC, which works with hedge funds overseeing about $6-billion. At the same time, the shift reflects lingering questions about the pace of policy changes and economic improvements, he said.

"The conversation I have with a lot of funds is, 'My crystal ball is really cloudy right now,'" Mr. Dunn said. "There's a lot of wait and see because the soft data is good, but hard data hasn't picked up."

Valuations stretched

Record U.S. equity averages and improving business and consumer sentiment are countered by mixed economic data. Many analysts lowered estimates of first-quarter growth after consumer spending, the U.S. economy's primary fuel, increased less than forecast in January. At the same time, the Federal Reserve is poised to raise interest rates as soon as this month.

The gap between two-year and 30-year interest rates, known as a yield curve, hovers near its lowest level in four months, data from Bloomberg show, suggesting limited potential for growth and inflation.

Though growth could pick up down the road, valuations may have stretched too far for comfort, said Mark Connors, Credit Suisse's global head of risk advisory in New York. Taking a more defensive position protects fund managers whose lack of bearish bets would leave them vulnerable to any sudden sell-offs.

"Caution, hesitation on valuations, whatever you want to call it, now they're digesting information while the yield curve is flattening, not steepening," Mr. Connors said.

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Credit Suisse based its estimates on data from its prime brokerage accounts, which offer trading and other cash-management services to hedge funds.

Defensive shift

To be sure, hedge-fund portfolios still contain more financial stocks than usual, according to Credit Suisse. But since December, they've reduced their net exposure to banks by 15 per cent, which is atypical considering the pending rate hike, Mr. Connors said. Before rate increases in 2015 and 2016 hedge funds added finance shares.

While profit-taking alone would be a logical conclusion to the 24-per-cent rally in the banking industry since the U.S. presidential election in November, evidence indicates a shift toward defensive plays.

Funds increased their gold exposure by twofold while selling base metals such as copper, which benefit from an uptick in growth, Credit Suisse data show. One large category of hedge funds that primarily trade futures, known as macro CTAs, are now net short U.S. equities for the first time since before the election, the data show.

Most notably, hedge funds ditched consumer discretionary companies this year. Such a move would suggest any economic recovery may not help the consumer, putting the onus on Washington to rev up growth through fiscal policy, a notoriously slow process, Mr. Connors said.

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"Until the rubber meets the road on timing, they're going to wait," Mr. Connors said. "It's not a reversal, but it's definitely taking some chips off the table and getting more defensive."

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