The cash is trash narrative of early 2022 proved to be the worst investment advice of the year (or even decade).
High rates of inflation and dismally low-interest rates led the masses to believe their money was best off investing in something... anything but cash. Yet, two of the best-performing assets this year, and particularly in recent months as the commodity rally has failed, have been U.S. dollar deposits and (ironically) Russian ruble cash holdings. As a result of the pain felt in stocks, bonds, and, more recently, commodities, investors have capitulated to the sidelines in a manner witnessed only during the dot.com blow-up and the Covid crash.
As we have learned throughout history when the masses are hitting the sell button and raising cash, it is usually a sign that the majority of the pain has already been felt. But that does not mean assets turn on a dime; in fact, even if the reversal is days away rather than months, the price change can be substantial. During the Covid-induced selloff in March 2020, the S&P 500 dropped 1,000 points in a few short weeks.
The current correction has incurred losses in a more civilized manner, but the door is still open for a capitulation probe lower. How low that probe might go is up for debate, but our charts suggest 3550 would be a bearish target and a price at which buyers might show up again.
Too Many Bears and Shorts?
There aren't many fundamental reasons to be bullish on the stock market, but market positioning should not be completely ignored either. According to the COT Report (Commitments of Traders) issued by the CFTC (Commodity Trading Commission), large speculators, those with deep pockets, large positions, and assumed to be the "smart money" are holding historically aggressive net short positions.
In the past, large net short positions held by this group of speculators have signaled the end of a correction not an extension of such. That said, we do acknowledge that this correction is of a different type than those seen in 2018 and 2020 due to monetary policy and the prolonged downtrend.
Even so, if speculators are already massively short in the futures market and long-term investors are holding large cash positions, there is a good argument to be made that most of the bears have already acted. At some point, the selling will dry up and short-covering will turn to short-squeezing, followed by FOMO investment dollars chasing stocks higher.
Chart Source: Barchart
While the trend is obviously lower, there are signs of life on the charts. A print above 3900 in the S&P 500 suggests prices are breaking out of the downtrend it has succumbed to since peaking in late March.
If the buy stop loss running turns into panicked short-squeezing, a run toward 4400 isn't out of the question. This would mark the longer-term downtrend line that dates back to late 2021. Most analysts aren't giving the market a chance in the hot place to get there, but it can.
If the record number of shorts decide to get out of their positions at the same time, the fundamental backdrop won't matter. We've seen this play out in the long commodity trade in recent months. Wheat prices fell from $13.00 per bushel to under $8.00 despite the media touting a global food shortage around the clock; anything is possible.
Chart Source: QST
It's Possible to Hedge Cash Holdings (intended for future allocation into risk assets)
We suspect the recent rally has some sidelined cash holders feeling like they could miss out. Chasing prices higher is generally a painful endeavor, particularly in a bear market. Yet, there is a way to hedge cash positions in a portfolio while we wait to see if this is a bull trap or the real deal. This can be done with risk reversal strategies. You might recall us writing about risk reversals as a way to hedge stock portfolios late last year and earlier this year.
When hedging a stock portfolio, risk reversals entail selling a call option and using the proceeds to pay for a put option. However, this time around investors might want to do the opposite; sell put options and use the proceeds to buy call options. To ensure we are on the same page, we are offering this as a way to hedge sidelined cash. In other words, this is a way to allow the trader to hold out for lower prices to get fully invested, but also be therefore the ride if prices move sharply higher before the investor has a chance to employ sidelined cash.
Here is an example of what a bullish risk reversal, or cash hedge, might look like. A trader could sell a September E-mini S&P 500 3520 put for about 40 points or $2,250 and then use the proceeds to purchase a September 4150 call for about 40 points. This leaves the trader with a "free" cash hedge. By free we simply mean there is no cash outlay other than commission and the margin (good faith deposit) required to hold the trade (about $6,900).
To clarify, the long call option gives the trader the "option" to purchase the S&P 500 at 4150 at expiration and the short 3520 put would require the trader to purchase the S&P 500 at 3520 if the index was below the strike price at expiration. Thus, for an investor with about $200,000 in cash waiting to be deployed near major support levels (3550 according to our analysis) but the desire to have a foot in the door just in case the 3500 handle isn't seen, this is a great way to have the best of both worlds. Keep in mind, that this could also be done with the micro futures, which would hedge about $19,500 in sidelined cash.
Chart Source: QST
At expiration, in about 59 days, this strategy expires worthless if the S&P 500 is between 3520 and 4150, but it pays off infinitely above 4150. As mentioned, the top of the trading channel is roughly 4350 so we would suspect a best-case scenario would be a gain of about 200 points or $10,000 ($1,000 for micro traders).
On the other side of things, if the ES collapses below support levels to trade beneath the strike price of the short put, the risk exposure is open-ended. It would be like being long an e-mini futures contract from 3520 (or about $175,000 worth of S&P 500 allocated stock). That said, if the goal is to invest that sidelined cash at or below 3550, being long a futures contract from that area accomplishes the goal quite efficiently and because there is idle cash backing the position, there is no leverage being used.
Those that don't have cash intended to be allocated to stocks on the sidelines could participate in this strategy for speculative purposes but doing so would become quite risky due to futures market leverage if we did see capitulation selling below 3520. In our view, this strategy at this point in time would be better used as a cash hedge -- those looking for speculative bullish risk reversals should wait for much lower prices (if they materialize).