Mid-week market update: What are we make of this market? In the last four years, the weekly S&P 500 chart shows that we have seen six corrective episodes of differing magnitudes. Risk happens, and sometimes with little or no warning.
About half of those instances saw negative 5-week RSI divergences, which we are seeing today. Since the start of 2019, when the ARK Innovation ETF (ARKK) started to get hot, the ARKK to SPY ratio roll over every time during those corrections. That ratio is turning down again.
The stock market is becoming a market of stocks, instead of a stock market. Individual issues are moving separately instead of together. In the past, low realized individual stock correlations have been warnings of market corrections.
Will this time be any different? The S&P 500 hasn’t seen a downside break of the rising trend line on the weekly chart yet.
Reasons for caution
The bear case is easy to make. Signs of froth are appearing everywhere. The PBoC warned about asset bubbles and withdrew liquidity from the financial system. The overnight repo rate spiked as a consequence. The Chinese and HK markets tanked on the announcement Tuesday, but steadied on Wednesday.
also reported that the “Goldman Team Sees ‘Unsustainable Excess’ in Parts of U.S. Market”.
Corners of the U.S. equity universe are showing signs of froth, but that shouldn’t put the broader market at risk, according to Goldman Sachs Group Inc.
Very high-growth, high-multiple stocks “appear frothy” and the boom in special-purpose acquisition companies is one of a number of “signs of unsustainable excess” in the U.S. stock market, strategists including David Kostin wrote in a note Friday. The recent surge in trading volumes of stocks with negative earnings is also at a historical extreme, they said.
However, the aggregate stock market index trades at below-average historical valuations after taking into account Treasury yields, corporate credit and cash, the strategists added.
In a separate article, Bloomberg
reported that the NAAIM survey of RIAs shows that the most bearish respondents are 75% long. To explain, NAAIM surveys RIAs from 200 firms overseeing more than $30 billion and asks their investment views. The survey reports an average equity exposure, an average top and bottom quintile exposures, and a maximum and minimum exposure. It is highly unusual to see the minimum at 75%. Most of the time, the minimum is negative, indicating a short exposure to equities. The last time minimum exposure was this high was the market melt-up in late 2017 and early 2018. Tom McClellan
recently made the same observation about the NAAIM survey and came away with a similar bearish conclusion.
As well, money market cash levels are low. Historically this has led to subpar returns.
From a seasonal perspective, February has historically seen VIX spikes. Since volatility is inversely correlated with the market, this implies lower stock prices ahead.
also observed, “When a new party is in power in the White House, that first year tends to be pretty choppy for the S&P 500.” Negative seasonality starts very soon and ends in March.
The market is due for a correction.
Here comes the flash mob bulls
There is no doubt that the market psychology is frothy and giddy. If you are unfamiliar with the Reddit flash mobs, take a look at the article
, “11 Things to Know About the Wild GameStop Drama on Reddit WallStreetBets (WSB)”.
To recap, small retail traders have identified highly shorted issue and ganged up to push the stocks up. These traders have mostly used call options to maximize their leverage, and to force dealers to hedge their positions by driving up the underlying stock price. Small trader option volume has surged to fresh highs as a consequence.
Indeed, most shorted stocks have gone wild on the upside.
The short squeeze targets are small cap stocks, and there is a linear relationship between the YTD performance of Russell 2000 stocks and their short interest.
Google searches for “short squeeze” have skyrocketed.
GameStop (GME) is the poster child of the short squeeze. Yet, even as GME rose like a rocket ship, the overall market reaction has relatively relaxed. The Russell 2000 VIX has risen but not spiked above its recent range, and the shares of CBOE has lagged the S&P 500.
How long can the WSB flash mobs prevail? Joe Wiesenthal of Bloomberg offered some perspective.
If you go back to the dotcom bubble, and you think about what stocks were really representative of it all, you probably think of Qualcomm or Cisco or Yahoo, or perhaps you remember TheGlobe.com. But some of the initial plays were a lot weirder. Back in the spring of 1998, traders went nuts for shares of K-Tel, the purveyor of corny compilation CDs that were sold via infomercials on TV. But when they started selling CDs online, the stock went bonkers, doubling many times over. Still, what seemed like irrational exuberance wasn’t anywhere close to the top of the market mania. It was barely even the beginning. K-Tel was like Hertz or the Scrabble bag.
It’s basically impossible to know in real time where you are in the cycle or how big things are going to get. Things can always get more nuts.
Before you think that the WSB pressure is restricted only on the upside, BNN Bloomberg
reported that “Short-squeezed hedge funds are now getting hit on their bullish bets too”. Hedge funds have to trim their long positions in order to balance the losses on the short books. In the alternative, some traders are being forced to liquidate because rising volatility is causing VaR (Value at Risk) models to reduce book sizes.
Hedge funds are suffering as retail traders whipped up in chat rooms charge into heavily shorted names, fueling squeezes in stocks from Bed Bath & Beyond Inc. to AMC Entertainment Holdings Inc. Fund managers have spent recent weeks paring bearish bets, with hedge fund clients tracked by Goldman Sachs on Friday carrying out the biggest short covering in seven months.
But the long sides of their books are starting to feel the pinch too. On Monday morning, when stocks with the highest short interest soared as much as 11 per cent, the GVIP fund tumbled almost 2 per cent.
Such a squeeze not only hurts performance for hedge funds, it increases the potential size of a measure known as daily value at risk, both of which would prompt money managers to cut back their risk appetite, according to Kevin Muir of the MacroTourist blog.
“The real question is whether this selling starts a negative feedback loop,” Muir wrote Monday. “Even though it might seem like the stock market bulls should be cheering the squeezes, their success might end up being the trigger that brings about the general stock market correction many have been waiting for.”
Should the WSB squeeze continue, it opens up the possibility of one or more hedge fund blowups, such as a repeat of the August 2007 quant meltdown (see Khandani and Lo paper
for more details).
In order to adapt to the new environment, I am changing my subscription pricing from being paid in USD, to being paid in shares of GME. This change will be immediate and apply to all renewals and new subscriptions*.
Risk levels are high
Tactically, today’s sell-off saw the S&P 500 violate a well-establish rising channel. In addition, the VIX Index surged above its upper Bollinger Band, which is the signal of an oversold market. The bulls need to hold the line here and rally. I am closely watching the behavior of the VIX. Will this a “once and done” spike, or an upper BB ride? Watch if there is any bearish follow-through.
My inner investor is bullishly positioned, but he has selectively sold covered calls against existing positions as a partial hedge. The long-term trend is still bullish, though short-term risk levels are high. My inner trader is holding his short position in the S&P 500.
* No, I am not serious. That’s a joke.
Disclosure: Long SPXU