The market’s ‘smart money’ is flooding into industrial stocks — but one Wall Street strategist warns investors are setting themselves up for disaster

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The market’s ‘smart money’ is flooding into industrial stocks — but one Wall Street strategist warns investors are setting themselves up for disaster

The so-called smart money is piling into US industrial companies, and one top equity strategist says investors may get crushed when the sector runs out of steam.

Major hedge funds snapped up machinery and shipping companies in the fourth quarter, and those stocks have posted market-beating gains in 2019. But when a trade gets too popular, it can create major risks, regardless of fundamental merit, according to RBC Capital Markets‘ head equity strategist, Lori Calvasina.

“When crowded trades unwind, it tends to be painful and difficult for investors to get out in time,” Calvasina said. “If the story changes, you’re vulnerable.”

The chart below shows just how strong demand has been for industrial stocks. The blue bars show the extent of hedge funds’ overweight or underweight positions on the sectors at the end of last year, and the orange dots compare that positioning with the norm since 2010.

As you can see, investors are drastically overweight industrials relative to history.

RBC Capital Markets / Lori Calvasina

The consensus on Wall Street is that industrials are very vulnerable to rising trade tensions, but Calvasina said hedge funds tried to avoid those weaknesses by buying domestically-focused companies like airlines, building products makers and professional services companies.

In an interview with Business Insider, she said there’s some good news: Hedge funds aren’t putting all their money into just a couple of companies, as they did with the tech and internet sectors at time. But there are also signs the overcrowding is getting even worse this year, as defense and road and rail stocks are making huge gains.

In terms of what could spur a sudden shift in industrial sentiment — the kind that could send investors fleeing for the exits — Calvasina highlights a slowdown in economic growth. Her concerns echo recent signs traders are getting worried about future growth, even amid a giant stock-market relief rally this year.

“Most of our baskets of crowded names struggled in 2016, when the growth trade last stumbled (as it appears to be doing now),” Calvasina wrote.

Economic growth is particularly critical for industrial company profits, as the sector is one of the most tightly linked to overall economic health. And while investors have set aside their fears and pushed industrials up 18% this year, Calvasina says the risks are substantial.

She says stocks in the industry are getting higher ratings from analysts than usual, while hedge funds shift an abnormal additional amount of money into the sector. Overall, Calvasina says industrials hit an all-time “overweight” high in the third quarter of last year and came down only a little in the fourth quarter.

That means the stocks could sink if analysts shift their views back to their historical norms, or if hedge funds change their positions.

On the flip side, hedge funds were underweight utilities and household products companies during the fourth quarter and reduced their positions, according to Calvasina. And those sectors have, in turn, lagged the market in 2019.

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