Are Top Hedge Funds Starting to Rotate out of U.S. Stocks?

The Global Equity Strategy team at Credit Suisse sees four key macro trends that will have an impact on equity prices in the coming months. These trends may be anticipated by hedge fund managers, expediting their lowering of U.S. stock exposure.

1. Global gross domestic product (GDP) appears to be accelerating for the first time in three years. Credit Suisse expects growth to jump from 2.70% in the fourth quarter of this year to 3.75% by the fourth quarter of 2014.

2. They see falling macro uncertainty. This is a relief to many who watched tiny countries like Greece affect world markets a few years ago. The Credit Suisse proxy of U.S. macro uncertainty has fallen recently to a six-year low. Analysts also think it is set to drop further as the U.S. budget deficit continues to fall (the Congressional Budget Office projects a 2015 deficit of only 2.1% of GDP). They also point out that Europe is recovering, and bank deleveraging there is diminishing. This could be another reason hedge funds are shifting money overseas.

3. Growth in emerging markets (EM) is slowing, relative to developed markets (DM). In spite of the recent rebound in EM leading indicators, the Credit Suisse analysts believe that growth in the EM will continue to disappoint relative to that in DM. This is due to excess private sector leverage, commodity exposure and limited spare capacity in their labor markets.

4. Bond yields will continue to rise. Credit Suisse expects that the yield on the 10-year U.S. Treasury will rise to 3.10% by the second quarter of 2014. This compares to a current yield of 2.61%.

Given those four key macro points, what are the top long/short hedge funds starting to do? The Credit Suisse analysts believe there are four main strategies that many funds are employing to reset their books and positions for the year to come. If they are lowering their U.S. exposure, these four strategies make good sense for investors as well.

1. Underweight consumer staples stocks. This means avoiding stocks like Procter & Gamble Co. (NYSE: PG), Colgate-Palmolive Co. (NYSE: CL), Kellogg Co. (NYSE: K) and Kimberly-Clark Corp. (NYSE: KMB). These stocks are negatively affected by all four of the macro trends. They also have poor earnings momentum and are definitely not cheap, even if they are solid defensive stocks with good dividends.

2. Underweight U.S. equities to global markets. The United States tends to underperform when global growth accelerates. Stocks are becoming expensive after the big rally this year. The safe haven appeal of U.S. stocks also starts to fade as global macro uncertainty does. Needless to say, geopolitical risk is always there, but it has subsided compared to a few years ago. Investors who are 100% in U.S. stocks may want to trim that to 60% or less.

3. Overweight stocks in Japan. The country has the highest operational leverage of any region in the world. When global growth picks up, Japanese stocks tend to outperform. Top stocks to buy could include Toyota Motor Corp. (NYSE: TM), Honda Motor Co. Ltd. (NYSE: HMC), Nippon Telegraph and Telephone Corp. (NYSE: NTT) and Sony Corp. (NYSE: SNE). Investors also could buy a Japanese exchange traded fund like the Wisdom Tree Japan Hedged Equity ETF (NYSEMKT: DXJ). This provides broad exposure to Japanese stocks but with a hedge against a weaker yen.

4. Overweight equities as a whole. This is in response to what should be a long period of rising interest rates. The Federal Reserve has kept interest rates at record lows since 2008. Concern is growing not only in the continued policy of low rates, but the Fed’s continued buying of bonds. Investors may want to trim their holdings in individual bonds and bond funds. Buying the ProShares UltraShort 20 Year Treasury ETF (NYSEMKT: TBT) is a way to be short the bond market without having to pay the carry on shorting individual bonds.

Hedge funds will stay exposed to the top stocks in the United States. Technology names will remain prominent in portfolios, as they have solid growth prospects and very low debt levels. The PowerShares QQQ (NASDAQ: QQQ) is a good ETF for investors looking for broad tech exposure. The key is to take gains in areas that are expected to weaken next year and move that capital to the areas with more upside. Making some portfolio changes now may help investors to continue to post solid gains in the coming year.