×

Why hedge fund pain could mean stock market gains

Investors are getting caught paddling upstream, and as they turn their bearish boats around, the tide will continue to rise for stocks, argues Tom Lee of Fundstrat Global Advisors.

"Investors are offsides right now," Lee said Friday on CNBC's "Trading Nation." "They're bearishly positioned at a time when the weaker dollar, rallying high yield [bonds] and the oil recovery are actually quite bullish."

Lee, a noted prognosticator who previously was JPMorgan's chief equity strategist, pointed out in a Friday note that "short interest has risen 12 of the last 13 months and is currently the highest level since 2009," with short interest as a percentage of tradeable (or "floating") shares currently at 4.4 percent.

"A trillion dollars' worth of equities is sold short," Lee said Friday. "Never in history has a trillion worth of short interest been covered in 30 days. It usually takes nine to 12 months."

In fact, Lee dove into market history to find that in 8 of the past 9 times when short interest rises while credit conditions ease, the S&P 500 has climbed over the next six months, with a median rise of 12 percent.

"This implies as much as 2,250-2,300," the perennially bullish Lee noted.

Whether stocks actually end up rising that substantially, Lee's bottom line is that "there's a huge amount of upside from here because we're talking a trillion sold short."

Read MoreThe nagging problem with the stock market's rebound

Neil Azous, an investment strategist at Rareview Macro, took a similar perspective in his Monday morning note to clients.

"It is one thing to underperform when the market is positive, but it is another thing to underperform when the market is negative," Azous wrote. "The fact is with quarter-end very near, the S&P 500 is slightly up YTD, but long/short hedge funds are down 3-7 percent. That makes them understandably nervous."

The windup of this nervousness is that "if model-driven strategies take hold of the market on the upside, and the bearish observations ... do not materialize, the pain in the hedge fund world will be that much more acute. And, that portends to even higher prices as they are forced to capitulate and join in."

In other words, the "pain point" for many large investors is located to the upside — which might be an argument that the market bounce has legs as this pain causes capitulation.

Videos

Trades to Watch

Trader Bios

About

Trading Nation is a multimedia financial news program that shows investors and traders how to use the news of the day to their advantage. This is where experts from across the financial world – including macro strategists, technical analysts, stock-pickers, and traders who specialize in options, currencies, and fixed income – come together to find the best ways to capitalize on recent developments in the market. Trading Nation: Where headlines become opportunities.

Brian Sullivan

Brian Sullivan is co-anchor of CNBC's "Power Lunch" (M-F,1PM-3PM ET), one of the network's longest running programs, as well as the host of the daily investing program "Trading Nation." He is also a frequent guest on MSNBC's "Morning Joe" and other NBC properties.

Read more

Connect