Mid-week market update: Everyone calm down. It’s not the end of the world. A clear-headed approach is to analyze the roots of the pullback from the perspective of the positioning of different market participants. How each reacted, and what might come next.
First, U.S. equities were overvalued. It just needed a bearish catalyst.
Here’s what happened next.
What happened?
From a trader’s perspective, the news flow was just an excuse The downdraft was mainly a price momentum unwind.
Easy come, easy go. Price momentum was mostly concentrated in the Magnificent Seven names.
Much like the metaphorical butterfly flapping its wings in Tokyo, the unwind was exacerbated by a surge in Japanese bond yields. The combination of rising JGB yields and falling Treasury yields put upside pressure on the Yen. A falling yield spread caused a disorderly risk-off episode and unwind of the Yen carry trade, in which investors borrowed in Yen and bought USD assets, in mid 2024. In light of the strong price momentum of the Magnificent Seven, some of the carry trade funds probably went into U.S. equities instead of Treasury assets. The combination of rising JGB yields, nervousness over an extended U.S. equity market, and trade war fears probably sparked a rush for the exits.
Goldman’s prime brokerage arm reported that hedge funds had been selling equities in size.
The buyers during this period of hedge fund liquidation were retail investors. We can see some of those effects from the AAII weekly sentiment survey. Sentiment remained sanguine in the early part of 2025, but panicked in the last two weeks as the selling accelerated.
What’s next?
What happens now? MarketWatch reported that a team at JPMorgan concluded last week that the momentum unwind is mostly complete, but qualified that conclusion with “if this a ‘structural regime change’ then the drawdown has further to go, with a potential pullback of 25% relative to the market”. In case you didn’t catch that, “structural regime change” is code for Trump-related policy disruption and uncertainty.
That’s another way of saying that the market should bounce under normal circumstances, but oversold markets can become more oversold. Indeed, the S&P 500 has breached its rising trend channel as the 5-week RSI has become oversold. The bulls need to mount a strong defense while the bears need more negative newsflow for stocks to continue falling.
What now? According to William O’Neil, investors are undergoing a “bad news panic market”. We just need to bad news to stop to start the relief rally.
Today’s softer-than-expected CPI report was a constructive development for a rally. However, I am inclined to reserve judgment until the S&P 500 breaches its 5 dma. Until then, the bears should be considered to be in control and this is a “sell the rips” tape. Let’s see if we can get bullish follow-through in the next few days.
My inner trader is still long the S&P 500 and he recently added to his position. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXL
It is also probably worth noting that we would expect a bounce here as we have hit a moderate support level on the MAGS chart at 46.3.
The next support level appears to be at the September low of about 42.9. This is probably a bit stronger than the current level.