Hedge Funds Slash Tech Stocks, Diversify Amid AI Bubble Fears

Hedge Funds Slash Tech Stocks, Diversify Amid AI Bubble Fears 

Three weeks ago, as stocks continued to surge, we questioned if the "Party Is Almost Over" when hedge funds began offloading record amounts of tech stocks to retail investors. This marked the start of significant liquidations, which we closely monitored. Recently, we reported that panic selling of tech stocks reached unprecedented levels as hedge funds exited the AI bubble, making tech stocks "Most Underweight On Record." Despite this sharp decline in tech exposure, hedge funds remained heavily invested in other sectors. The sell-off in the major tech stocks (Mag 7) triggered increased volatility, leading to broader market sell-offs. According to Goldman's Prime desk, this activity is part of a broader market rotation and significant R2K vs SPX outperformance.

Hedge funds have been reducing their risk exposure in US equities. Goldman PB provides the following details. Gross trading activity in US equities has declined for five consecutive sessions on the Prime book as of COB 7/16, driven by a ratio of 1.3 to 1 for short covers to long sales. In cumulative notional terms, the de-grossing activity over the past five sessions is the largest since November '22, ranking in the 99th percentile on a five-year lookback. De-grossing was observed in 10 out of 11 US sectors excluding Staples, with Info Tech, Industrials, Health Care, Consumer Discretionary, and Communication Services leading the activity.

This sharp de-grossing did not result in significant performance losses. Goldman reports that long/short L/S funds, particularly the Fundamental L/S cohort, have remained relatively unscathed this month, with long-side gains outweighing short-side losses. Fundamental L/S Total Returns are up 1.7 percent in July MTD alpha -0.15 percent, now up 9.2 percent YTD alpha 3.8 percent. Systematic L/S Total Returns are down 2.1 percent in July MTD, now up 14.3 percent YTD.

Tech stocks continue to see significant net selling, with hedge funds reducing their net length across the sector. All tech subsectors were net sold in the past week, with the aggregate US Info Tech long/short ratio now at 1.82, approaching five-year lows.

Goldman trader Matthieu Martal notes that managers are aggressively diversifying, leading to significant thematic rotations. He warns that positioning resets can extend before fading, suggesting that factor rotations and crowding unwind dynamics are expanding globally. Martal emphasizes the importance of hedging in this context, particularly as AI earnings season approaches, where only exceptional results might suffice to prevent downside risks.

Martal also highlights that we are in the midst of a crowding unwind, with the Russell rally appearing overdone amid a cyclical slowdown. Despite record de-grossing in the US, concentration issues persist outside the US, exemplified by ASML. Europe remains a liquidity trap, with critical momentum levels resetting.

Moreover, Martal warns of growing challenges to AI growth prospects and the potential risk of an AI Capex bubble. Historically, NVDA has seen significant corrections during capex rollovers, hinting at a possible tech bubble burst. The construction of necessary infrastructure like datacenters is also lagging, potentially leading to bottlenecks.

Goldman trader Rich Privorotsky suggests timing the bursting of the tech bubble by waiting for negative tech sales revisions. Goldman recommends taking profits on AI Capex investments.

Overall, Goldman's sentiment is increasingly bearish. Equity risk premiums are low, and systematic positioning remains high, posing a contagion risk. While hedge funds are bearish on Europe, they are not yet positioned bearishly. Hedge fund exposure to tech is at its lowest since COVID, contributing to a relatively calm market sentiment, with no signs of panic yet. This is seen as an opportune moment to adjust positions in high-visibility portfolios.