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Expecting A Pullback - You May Be Waiting For A While.
Listening to the market chatter, it seems that the majority of market participants believe that Thursday's rally is unsustainable. I've come to a different conclusion.
For the entire month of August, the market was in a consolidation period. It was a battle between the bulls and the bears as the S&P futures traded between 1395 and 1420 for the better part of the month.
(click to enlarge)
Thursday's Draghi spike opened the market into a critical resistance area. This looked like a nice setup for the shorts as the market opened up at the top of its recent range.
But this market threw those shorts a curve ball. We opened up in the 1412 area and never looked back, continuing straight up for another 28 points. This caught three different types of market participants by surprise:
1) Fundamental traders - that were banking that the Draghi spike would be short-lived used the opening print on Thursday to add to their short positions. Many of these traders expected the unemployment data to be poor again (just like the previous three reports), so they stubbornly held onto those short positions and have possibly added to them on Friday.
2) Technical traders - that had previously played the index short from the 1414-1418 area shorted this open as well.
3) Opening traders (OPG traders), who employ a fair value type of strategy where they calculate the fair value of the individual components of the S&P based on where the S&P futures are trading. They buy those securities that are undervalued, and sell the securities that are overvalued relative to the S&P fair value. These traders also got caught short on the open, as many individual components opened slightly above their calculated fair value.
All of these traders were under serious heat very quickly on Thursday morning as the index, and the majority of its major components, never had any type of significant pullback.
(click to enlarge)
This short squeeze drove the market up to the 1430 area in the first hour of trading. We have now had a full day of consolidation and it is again a battle of the bulls and the bears, but this time I believe there are significant bears that are sitting on some ugly short positions. Many of the traders that shorted Thursday's open are still sitting on these losing positions hoping for a pullback. I've learned one thing in my 13 years of trading, when you start hoping in a trade you are usually in big trouble. I think those traders that are still shorting this market and hoping for a pullback are going to be rudely awakened, as I think the next major market move is going to be up again. Stay tuned to see if this market can squeeze these shorts further.
Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
End Of The Quarter Window Dressing
Therefore, stocks that have had a good quarter, often have a good couple of days at the end of the quarter as fund managers accumulate positions in those issues. For example, take Coke (KO), it has had crazy buy imbalances at the end of the close the last two days, probably due to some institutional investors trying to accumulate stock. It very well may have a large buy imbalance again today for the same reason, this would press a stock like KO higher into the close. Overall, since the entire quarter has been very strong, there could be some significant accumulation in a number of issues at the end of the day today.
These gains are typically short lived, as these stocks will often give back their gains in the following week or two. In any regard, if stocks do rally into the close, it may be a good idea to lighten up on some of your longs.
Financial Transaction Tax Punishes Main Street more than Wall Street
DeFazio tried to propose a similar tax a couple of years ago, but the proposed bill never gained much traction. But now that the European Union has proposed a financial transaction tax, DeFazio is hoping that his proposal can gain more support this time around.
In theory, this tax would raise a substantial amount of revenue. However, it would come with some substantial costs, the most significant being a decline in market liquidity. Market liquidity refers to a stock's ability to be sold without substantially impacting price. The majority of our market liquidity is provided by market makers. These market makers (some being high frequency trading firms) have very small profit margins. A modest transaction tax of 0.03 percent (which is being proposed), would have drastic effects on the market making business. Let's take a quick look at the math.
Many of our most highly traded stocks have bid-ask spreads of one cent. A stock that is trading at $25, would have a transaction tax of ($25 x 0.0003) = $0.0075 per share. If a market maker were to buy this stock at $25 and sell it at $25.01. They would make 1 cent/share, but would have to pay 1.5 cents/share in tax (they have two transactions, the buy and the sell). Therefore they would lose 0.5 cents on the transaction. In order to remain profitable they would have to widen their spreads to a minimum of 2 cents, and possibly further (as market makers aren't always profitable on every trade). Wider spreads means more price impact for institutional traders as they make trades, and this added expense comes right out of the pocket of the individual investor who invests in the fund that is trying to transact. The bottom line is that market makers (some being high frequency traders) are still going to make money, they are just going to trade with wider spreads in order to do it. This is an indirect cost to Main Street, not Wall Street.
The direct cost is that the institution transacting would have to pay the transaction tax as well. So another 0.03 percent comes out of the pocket of the individual investor investing in the fund, every time the institution makes a trade. This number may sound small but imagine an institution that trades 200,000 shares of a $50 stock. The transaction fee on that transaction alone would be $3,000. Many actively managed funds trade much higher volume than that in a single day. These costs would quickly add up, again punishing Main Street.
What would naturally happen is that institutions would become hesitant to trade, and may hold onto a position they would otherwise sell, just to avoid paying the transaction fee. This could lead to large losses in positions that may have otherwise been liquidated. Who would bear the brunt of these indirect costs? Main Street again.
So I would argue that Wall Street would not bear the brunt of this tax. Wall Street traders will simply evolve to the new environment by widening their spreads. In the end, Main Street will pay.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.