The Big Short Squeeze Ahead

by: Clif Droke

Amazingly, bearish sentiment has increased despite recent rally.

Short interest, plus increasing momentum, equals short squeeze.

Bank, broker/dealer stocks also point to continued improvement.

Short covering has been in evidence since the end of December and still hasn't run its course. After near-record levels of investor pessimism last month, the major averages established a bottom and commenced a recovery rally which is still underway. While many bears believe the rally is approaching its end, the evidence we'll discuss in today's report points instead to an even bigger short squeeze in the coming weeks.

If there was any question that the broad market recovery now underway is more than just a "dead cat bounce," the remarkable performance of the financial sector provides the answer. Bank stocks as measured by the PHLX/KBW Bank Index (BKX) have climbed in 14 of the last 16 trading sessions, culminating with a 1% rally on Jan. 17. This compares to the S&P 500 Index (SPX) being up in just 12 of the last 16.

What's more, BKX has now slightly exceeded SPX in terms of relative performance as of Thursday after lagging the benchmark index since December. Bank stocks, in other words, are on the brink of regaining a leadership position over the market. This is a welcome development from a short-term technical perspective. As we've discussed in previous reports, leadership in the banks is historically a sign of a healthy market. Since bank stocks are sensitive to shifts in the financial market winds, the inference is that when the banks and other financial sector stocks show relative strength for an extended period, informed investors are confident with the broad outlook.

PHLX/KBW Bank Index

Source: BigCharts

The fact that fourth-quarter earnings have been mostly impressive for the major commercial banks has helped the bullish case for bank stocks. Bank of America (BAC) and Goldman Sachs (GS) were among the big winners of this week's earnings reports, while Wells Fargo (WFC), Citigroup (C), and JPMorgan Chase (JPM) reported a mixture of positives and negatives. The overall tone and tenor of bank earnings to date, however, has been encouraging. The recent strength reflected in the financial sector stocks also suggests that the U.S. economic outlook is still positive. Banks require a strong economy and a healthy interest rate environment in order to prosper, and the latest round of bank earnings implies that both conditions are present.

Joining the banks in their strong performance are the equally important broker/dealer stocks. The NYSE Arca Securities Broker/Dealer Index (XBD) has returned to a decisive relative strength position versus SPX, as can be seen in the following graph. XBD is arguably an even more sensitive indicator to changes in the financial market winds than BKX. After a low in the major averages has been established, it's always encouraging to see leadership in the broker/dealer stocks. When the banks and broker/dealers get synchronized, it can be taken as a sign that investors are focusing on the market's positive aspects rather than looking for excuses to sell.

NYSE Arca Securities Broker/Dealer Index

Source: BigCharts

If the continued improvement in the financial sector stocks isn't a "heads up" that more short covering potential lies ahead, the following chart exhibit should drive that point home. Shown here is the four-week rate of change (momentum) in the NYSE new 52-week highs and lows. This indicator has been rising in near-vertical fashion since late December and can be likened to a burning fuse. The powder which this fuse will eventually ignite is of course the short interest which still permeates the market.

Source: WSJ

The above chart of the NYSE new highs-lows momentum graphically depicts the powerful improvement in the incremental demand for equities now taking place. It presents a picture of health for the broad market and in no way suggests any signs of distribution of selling pressure underway. A sustained rally in the new highs-lows momentum indicator is one of the strongest indications that the market is vulnerable to a short-covering rally since the 52-week highs, and lows reflect the overall path of least resistance for stocks.

In what can only be another blow to the shorts, the latest investor sentiment poll released by the American Association of Individual Investors (AAII) showed that only 33% of its members were bullish this week - a 5% drop from last week. On the other hand, 36% of AAII members were bearish, which represents a 7% increase from the previous week. This implies that despite the impressive rally of the past several days, individual investors are becoming even more bearish and clearly view the rally with skepticism. From a contrarian's perspective, this supports a bullish intermediate-term outlook on the stock market. It also suggests that there is still plenty of short interest overhanging the market which can be used to fuel additional rallies in the coming weeks.

Also worth mentioning is the potential "W-bottom" in the emerging market stocks now taking shape. Shown below is the daily graph of the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM), a worthwhile overview for the emerging market stocks in the aggregate. EEM is now up by almost 6% at the start of 2019 and is being buoyed by, among other things, an improvement in the crude oil price and a more benign interest rate outlook for many EM countries like Indonesia. Keep in mind that it was the slowdown in the emerging markets last summer which served as a primary catalyst to the U.S. stock market plunge in October. With emerging market equities now on the mend, however, the bullish case for U.S. stocks has yet another important backing.

iShares MSCI Emerging Markets ETF

Source: BigCharts

In the final analysis, the stock market's fundamental backdrop remains sound while its short-term technical picture is continuously improving. Investor sentiment meanwhile fully supports an optimistic bias since too many retail investors are obviously pessimistic on the corporate profit outlook. The indicators we've reviewed in the last couple of reports suggest a potentially powerful short squeeze lies ahead for stocks. Investors are therefore justified in leaning bullish and avoiding the short side of the market at all costs.

On a strategic note, some conservative buying can be done in the sectors and industries which are showing the most relative strength and solid fundamentals. In particular, investors should be looking at consumer staples, pharmaceuticals, and financials, as well as the tech sector in general.

Disclosure: I am/we are long SPHQ, IAU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.