We are fielding a steady stream of questions from our brokerage clients, wondering how the equity market can move higher in the face of a disastrous backdrop of high inflation, interest rate hikes, and economic dysfunction that includes a lower gross domestic product, but a historically tight labor market. The reality is that fundamentals aren't always the primary driver of price; investors are.
Markets, and prices, are the culmination of human decisions and resources. There is nothing stopping investors from buying the highs or selling the lows; in fact, that painful reality is more common than we would like to admit. Thus, in the short run, market prices can behave in a much different manner than the underlying fundamental data might suggest would be reasonable. Price anomalies happen on the way down, as well as on the way up, due to investor motivation to protect capital and or achieve it.
Additionally, markets are forward-looking, which often means the next market move is the least obvious one. Although pessimism is at historical highs, it might be that speculators that wanted to be short have already sold and investors that wanted to reduce risk exposure have already liquidated. If so, regardless of noticeable fundamental headwinds, the stock market can continue to go higher as the very bears betting against the rally contribute to its magnitude via short covering. Similarly, long-term investors who liquidated near the June lows are likely regretting their decision and starting to chase prices higher.
So, Is This a Bear Market Bounce?
Nobody knows the answer to this with certainty, at least not until after the fact. Thus far, it is in line with historical bear market rallies in terms of scope and size (during the financial crisis era in the early 2000s, 10% to 20% rallies were common). Further, the S&P 500 is coming up against both trendline resistance and multiple moving averages that could reject prices from 4,3800 to 4,400 at a time when the Fed is still touting a heavy-handed approach. But we don't think there is room for being complacent regardless of your positions or opinions. The reality is the market could continue to climb the wall of worry.
Here are a few arguments for a continuation of the upswing beyond what most consider to be reasonably possible.
Speculators? They're Already Short
According to Friday's release, the large speculator category of the Commitments of Traders report issued by the Commodity Futures Trading Commission was holding a net short position of about 244,000 futures contracts. But if you use the data that combines both futures and options positions, the net short position is near 300,000 contracts. This is a historically lopsided holding; we have only seen speculators this bearish on a few occasions. The first was in the fall of 2011 and the other was in May of 2020. Each of these oversized short positions occurred a few months after the market bottomed and likely added fuel to the fire on the upside as traders unwound the overcrowded short positions throughout stunning melt-ups. Will we see a repeat?
If you are questioning how this could happen in the face of a global slowdown, it is worth noting the aforementioned scenarios were accompanied by horrific economic conditions (a financial crisis and a complete economic shutdown). It could be argued that the Fed raising rates at a faster pace than they ever have to defeat a 40-year high in inflation, is child's play when compared to a nearly complete closure of the global economy. In other words, we've seen unstoppable and inexplicable rallies in worse conditions than the current.
Money, Money, Money
The Federal Reserve embarked on a quantitative easing journey during the financial crisis and doubled down on that policy to fight the Covid-shutdown. The result has been a massive increase in the amount of money circulating in the economy. The goal of QE is to increase asset prices by increasing the money supply; the final objective is to artificially keep interest rates low and the wealth effect high (people tend to be more confident in their finances and spend more when their home value and stock portfolio are performing well). While the Fed has recently begun the process of quantitative tightening, it is in the early stages of the procedure and it has merely stabilized the money supply, not reversed it. Perhaps this is a sign that there is still too much money chasing too few assets. If so, both stocks and bonds could melt up together as investors seek places to park money. Of course, at some point the game of Federal Reserve market manipulation will have a tragic end, but for now, quite a bit of liquidated investment dollars are looking for a place to go.
Breaking 4,400: Mother of Alll Squeezes
A weekly chart of the E-mini S&P 500 confirms an obvious down-trending trading channel with prices on the verge of a breakout to the upside, or what could be one more painful collapse toward 3,500. The difference between the consequences is substantial. Few are giving the market a chance to breakout to the upside; the majority are positioned for a retest of the low or a fresh low. Sentiment surveys we follow suggest only 30%
to 35% of market analysts and participants are bullish. This is far less optimistic than we saw during the previous bear market rallies in March and May. As a contrarian, I have to wonder if this is a sign that a break above 4,400 could trigger the "Mother of all Squeezes."
My Bet
I would not say I was bullish; in fact, if resistance near 4,400 holds I believe things could get ugly fast. Yet, I'm keeping an open mind about the potential of an upside breakout. All of the signs are there to suggest it is a real possibility. In fact, I believe it is more likely than a reversal back into the bear market. If portfolios are short (not as exposed to stocks as they should be) and speculators are short (short futures or stock), the most motivated market participants will be those buying because they have to, not because they want to. One must never underestimate the ability of the market to cause the most pain to the highest number of people; a melt-up would do just that.
Chart Source: QST, Barchart, FRED
