GOLDMAN SACHS: Hedge funds have plunged into a 'vicious downward cycle' with the most popular stocks, and it's a sign the meltdown is just getting started

The average hedge fund is underperforming year-to-date, dragged by the sell-offs in popular tech companies, according to Goldman Sachs.Goldman's analysis of funds' third-quarter activity showed a continued rotation towards more defensive sectors of the market.Several strategists are advising investors to increase their cash levels heading into 2019.Not even hedge funds have been able to escape the ongoing correction in the stock market.The average equity hedge fund is down 4% this year, dragged by sell-offs in the popular technology companieslikeApple and Facebook that populate their portfolios, according to Goldman Sachs.Hedge funds managed to shake off the market's 10% correction in February andoutperform the S&P 500 in the first half of the year. But the second half has not been so kind to them, as the momentum that lifted stocks on the way up remains elusive. And after examining how they were positioned as of the end of the third quarter, Goldman concluded that the pain is just getting started."Hedge fund returns, portfolio leverage, and the performance of popular stocks have entered a vicious downward cycle," Goldman's Ben Snider said in a note."After outperforming in 1H 2018, our Hedge Fund VIP basket of the most popular long positions has lagged the S&P 500 by 725 bp since mid-June (-9% vs -2%) alongside a downturn in growth and momentum stocks and the rise in S&P 500 volatility."Read more: Goldman Sachs uncovered an investing strategy that's beaten the stock market for the last 15 yearshere are the stocks it says you should be buying and dumping right nowA laundry list of worries and a dearth of positive catalysts prompted investors to wipe out the stock market's year-to-date gains just before Thanksgiving. Interest rates are rising, the US-China trade war is raging, earnings growth appears to be peaking, tech giantsare threatened by regulation, and pockets of the US economy like housing and business investment are under strain. Hedge funds' response to these concerns has been to turn more defensive, Snider said, further signaling their low conviction that a swift turnaround is on the cards.Funds steadily reduced their net exposure to stocks during the second and third quarter even though the market was rallying to new highs. They're now the least exposed to stocks since the first half of 2017, although Snider noted that's still much higher than levels seen earlier in this cycle.As hedge funds sold tech stocks, they rotated to sectors that are considered safe havens in times of turmoil, including utilities and consumer staples. Healthcare makes up 18% of hedge fund net exposure, the largest of any sector relative to the Russell 3000."A number of current hedge fund net sector tilts stand out as extremes relative to the last decade," Snider said."The utilities overweight is the largest in the recent past, and the 503 bp tilt away from information technology is the largest underweight since 2014. Among the classic cyclical sectors, hedge fund overweights in energy and materials are at or near decade lows, while the industrials overweight is a record high."Snider included the caveat that the hedge-fund data used in his analysis does not include derivatives like futures, swaps, and options, which are used to speculate on the market. Hedge funds are not required to disclose those positions.Amid the rotations revealed in filings, Goldman and other firms are advising investors to consider cash as a defensive asset class in the year 2019 because equity returns could be weak."Bonds' elevated rate risk and zero-yielding cash allowed stocks to handily win the asset class beauty contest [for much of this cycle]," Savita Subramanian, the head of US equity and quant strategy at Bank of America Merrill Lynch, said in the firm's 2019 outlook."But cash yields today are higher than the dividend yield for 60% of S&P 500 stocks."Snider also observed, for the first time, that stocks' popularity with hedge funds is a signal of future price movement. The stocks that surge in ownership among hedge funds in a given quarter outperform the market in the following quarter and year, while the most sold stocks underperform.This makes their recent rotation to defensive sectors of the market even more telling of what's to come.SEE ALSO:Goldman Sachs uncovered an investing strategy that's beaten the stock market for the last 15 years ' here are the stocks it says you should be buying and dumping right nowJoin the conversation about this storyNOW WATCH: The first woman in space almost didn't make it back to Earth and she had to keep it a secret for 30 years
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