When investors’ nerves are wound tight, it doesn’t take much to set off an emotional reaction which can lead to a major short-covering episode. We got a small taste of that after the 1% pullback in the S&P 500 Index (NYSEARCA:SPY) on Thursday, as the long frustrated bears were heard growling with delight. As we’ll discuss here, however, a pullback in a market environment this technically strong can be quickly reversed. More importantly, any additional market weakness in the immediate term will result in even a short interest build-up that will serve as the catalyst for the next leg higher in the major averages.
Thursday’s trading session was a microcosm of what will likely transpire in the next few days. After waiting for what has seemed (to some) as an eternity, the market finally had a measurable pullback. In the current environment, “measurable” is anything over 1%. The latest SPX pullback was also an example of how spoiled even the bulls have become, for in this low-volatility market climate of the last several weeks, there has been a complete absence of turbulence. There were also audible squeals of delight from the bears, if the online investment boards were any indication.
The latest pullback in the SPX affords two opportunities for those who were caught heavily short at the December bottom. One is the temptation to cover any losing short positions which were initiated near last year’s correction low. Some participants will no doubt succumb to this temptation. However, another choice for many bearish traders is to initiate new short positions under the assumption that the major averages are in a bear market and that the latest rally has reached its terminus.
Shown here is the daily graph of the S&P 500 Index (SPX), which is on the verge of finally testing its nearest trend line of any significance: the 15-day moving average. After a 14% advance in just over six weeks time, the SPX has certainly earned the right to rest for a while and surrendered some of its gains while consolidating. If the benchmark index closes under its 15-day MA on a weekly closing basis on Friday, we’ll have the first reversal of the immediate-term trend this year. Yet most of the S&P’s gains since the Dec. 24 low should remain intact for reasons we’ll discuss here.
One of the factors which allows for the market to take a needed rest and consolidation period is the fact that short-interest levels have been rapidly dropping in the last couple of weeks. According to recent statistics, the SPDR S&P 500 ETF Trust (SPY) saw a notable decline in short interest last month. For much of the last several weeks, the SPY was at the top of the list of the most heavily shorted equities and funds. Yet SPY has surrendered its pole position as its short interest has rapidly dwindled.
This is a good indication that the market needs to be revitalized. And the best way to do it is for the market to give the bears some hope that the “next leg down” of a bear market has begun. Since the SPX failed to clear above its widely-watched 200-day moving average this week, we should see short interest building up again - especially on days when the SPX declines by more than 1%.
Another sign that the market needs to be revitalized on an immediate-term basis is the latest sentiment survey from the American Association of Individual Investors (AAII). In the poll released on Feb. 7, it was revealed that the percentage of AAII members who identified as bulls increased eight percent from the previous week to 40%. The bears by contrast fell nine percent to 23%. This is one of the biggest bull/bear disparities in favor of the bulls in quite some time. This also marked the first time this year that bullish sentiment was decisively high, i.e. above the average of the last few months. As AAII observed in its latest sentiment blog:
Optimism about the short-term direction of stock prices jumped to a three-month high in the latest AAII Sentiment Survey. Neutral sentiment also rose, while pessimism plunged.”
This rapid shift in investor psychology serves a clarion call that the market needs to wring out some of this excess optimism before continuing its climb. Too many bulls and not enough bears is not an ideal configuration for a market trying to absorb the excess supply of shares that were dumped onto the market last year.
While we’re on the subject of sentiment, it’s insightful that the latest pullback was triggered by a revival of worry over the U.S.-China trade war. This tells us that investors haven’t completely capitulated to the bullish trend of recent weeks and are ready to quickly embrace fear. This will help to quickly rebuild short interest levels and will help repair the chinks which had recently begun to appear in the market’s “wall of worry.”
One undeniable sign that the stock market remains internally sound is that the number one area of weakness last year, namely interest-rate sensitive securities, are no longer subject to selling pressure. Instead, some of those very same rate-sensitive stocks and funds which consistently populated the list of new 52-week lows in 2018 are now showing up in the new 52-week highs list. Consider that on Thursday many of the NYSE new 52-week highs were comprised of real estate equities and municipal bond funds.
Indeed, it was the widespread fear of rising interest rates that served as the initial catalyst to last year’s broad market decline. This fear was also the most enduring as rate-sensitive equities started making new 52-week lows back in September. As long as the interest rate issue remains on the sidelines, there’s little reason to assume that the U.S.-China trade war will serve as a catalyst to renewed internal weakness.
Another observation along these lines is that the momentum of the NYSE new highs-lows remains positive. Shown below is the 4-week rate of change of the cumulative 52-week highs and lows. This is my favorite measure of the market’s near-term path of least resistance, as the new highs and lows reflect the incremental demand for equities. As long as this indicator is in a rising trend, the bears will still face stiff resistance in their efforts at regaining control of the immediate-term trend.
More importantly, as long as the number of NYSE stocks making new 52-week lows remains below 40, it can be assumed that internal selling pressure isn’t a problem. If the new lows exceed 40 for a few consecutive days, then it will be time to become defensive and raise cash levels to some extent. For now, though, a bullish stance is still warranted in spite of the reappearance of trade war fears.
With the market somewhat vulnerable to a pullback right now and also sensitive to news headlines, a pullback of around 3-4% in the major averages wouldn’t be surprising. However, given the tendency for traders to quickly turn bearish at the first sign of trouble, I expect any further declines in the SPX in the coming days to be met with increasing short interest which will in turn spark another rally to higher levels. The stock market’s fundamental profile remains strong based on the results of the latest earnings season.
Moreover, the market’s short-term internal profile also remains sound based on the new highs-new lows as discussed above. The only major factor in need of improvement is market sentiment, which is a little too optimistic right now. Another 2-3 downside days like the one we saw on Thursday, however, and even this problem would likely be fixed.
On a strategic note, investors should be long 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 real estate equities, as well as the tech sector in general. I also recommend that technical traders take some profit in market tracking ETFs, such as the Invesco S&P 500 Quality ETF (SPHQ), of which I’m currently long. After the impressive upside run of the last few weeks, now would be a good time to book a little profit and raise stop losses on long positions in the event my bullish thesis is wrong and selling pressure increases.
Disclosure: I am/we are long SPHQ, IAU, XLE. 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.