Equities are falling out of favor after a 20% rally earlier this year as hedge funds build more bets against stocks in recent weeks, reports an article in Bloomberg. Hedge funds’ net leverage fell by 4.2%, the steepest decline week-by-week since 2020. Meanwhile, the funds increased their short sales, according to data from JPMorgan Chase that is cited in the article.

The driving force behind the negativity against equities is the Fed’s inclination to keep interest rates high for longer than expected. That’s putting pressure on market valuations, already stretched thin: in July, the S&P 500 was trading at a record-high 20 times forecasted earnings. While a dip in net leverage indicates that “smart money” is taking a more bearish position on equities, gross leverage, which totals both long and short positions, is heading in the opposite direction as shorts are rising. Those gauges moving in opposition signals that hedge funds are taking a firm stance against stocks. Indeed, after that July peak, the S&P 500 is now down nearly 6%, according to the article.

This type of defensive positions could potentially result in a bounce, though it could also help the market avoid getting too hot. At Morgan Stanley, clients are betting against pricey tech stocks, companies that benefit from AI, and consumer retail, while at Goldman Sachs their most-shorted stocks basket has dropped over 10%, giving those bearish investors a nice reward. But at JPMorgan, analysts purport that bearish cohorts had a flat monthly return in August and are now down 1.8%, because the group’s long positions didn’t produce high enough returns. In a note, the JPMorgan team wrote of the potential risk that the situation “goes in reverse and puts more pressure on performance, either via longs if the market continues to weaken or via shorts covered if the market snaps back,” concluding that “The best environment (for alpha) is likely one where the market remains range-bound and the macro backdrop appears supportive, but not too hot,” Bloomberg reports.