Stock market optimism about U.S. President Donald Trump's economic agenda is overdone and political risk in Europe isn't priced in, according to some hedge funds who are betting that the rally in equities is coming to an end.
The level of shorts - a bet that a stock will fall - taken out against the Dow Jones Industrial Average (DJIA) jumped 13 percent in the 30 days to Feb. 20, while shorts against Europe's STOXX 600 rose 18 percent over the same period, data from FIS' Astec Analytics showed.
Trump's promises to cut taxes and roll back regulation have fueled hopes of a pick-up in the U.S. economy, sending stock markets to record highs, with the Dow Jones up 13 percent since his election victory. Optimism that European companies will also benefit has pushed the STOXX 600 up 11.7 percent this year.
But hedge fund managers like Seth Klarman, who has been running $30 billion Boston-based hedge fund Baupost Group since 1982, worry Trump's polices may cause a sharp rise in inflation, while his protectionist tone on trade could hit other major economies.
"We could find ourselves at the beginning of a lengthy decline in dollar hegemony, a rapid rise in interest rates and inflation, and global angst about the stability and wisdom of American leadership," Klarman said in a letter to investors on Feb. 8 that was shared with Reuters.
"The Trump rally ��� in my opinion ��� saw global markets price in a huge amount of hope around his campaign promises, while ignoring the knock-on risks to fragile economies like Japan that export to the U.S.," said Shannon McConaghy, a portfolio manager at London-based Horseman Capital.
Marcato Capital Management, an activist investment firm, told clients on Jan. 27 that it exited equipment rental company United Rentals, a big beneficiary of Trump's calls for infrastructure spending. Marcato said it expects "any industrial recovery will take longer to flow through to earnings than would justify the multiple expansion."
A representative for the fund declined to comment.
While European stocks have also benefited from the Trump rally, some money managers believe the buoyant mood may soon give way to anxiety about French, German and Dutch elections this year.
Hedge funds aim to pick out trends ahead of other investors, a strategy that earned some of them billions ahead of the 2008 financial crisis when managers like John Paulson bet against sub-prime mortgages.
But the industry has had mixed fortunes since then, losing on average 1.1 percent in 2015 and making 5.5 percent in 2016, according to data from industry tracker Hedge Fund Research.
CASE FOR GOLD
Some managers are holding fast to the eventual benefits of Trump's plans to cut taxes and stimulate growth in other ways: the total volume of shorts in European and U.S. companies is still below levels seen at the end of November and December, respectively, according to data from FIS' Astec Analytics.
"The way that I look at markets right now, there are a couple of things that speak for a continued upside ... so we do not believe there will be a correction soon," said Lars Franstedt, chief investment officer and partner at $150 million Swedish hedge fund firm Madrague Capital Partners.
Some others, however, are reducing leverage - the amount they are borrowing to invest in stocks - even if they are not yet scaling up their short positions.
"I hear among our managers some skepticism about the sustainability of the rally. As a result, gross leverage is low on average," said one London-based investor in hedge funds.
To some investors, buying gold feels like the right insurance policy in case wider issues come home to roost.
"We believe the case for gold is broader," David Einhorn's Greenlight Capital told investors on Jan. 17. "Greater economic, geopolitical and policy uncertainties, much wider budget deficits, and the possibility of an inflation problem all support gold (to say nothing of what might be required to redecorate the White House to Mr. Trump's tastes)." (Reporting by Maiya Keidan; Editing by Susan Fenton)