Have you ever felt confused by how the stock market can fall when the news seems good and yet rally when the news seems bad?
I have found that focusing instead on things like price action, sentiment, and market internals is a far more successful approach than following the news...and the herd that regurgitates news headlines!
Research shows us that the stock market is most likely to find a bottom when sentiment is very bearish and reach a top when sentiment is very bullish. The crowd tends to be hopelessly wrong at critical turning points.
I remember when back in March 2020 - near the low of the COVID crash - I started posting some bullish remarks on social media. I was generally met with a torrent of... disagreement (I’m being polite!)
I have found social media can often be a good testing ground for sentiment. If I’m getting ripped to shreds in the comments for posts I’m making...that’s when I KNOW for sure I’m onto something ;)
A similar thing happened on Monday last week ;)
Let’s review what “everybody knows” in today’s market and dig a little deeper into sentiment and market internals.
What everybody knows
“Always beware what everybody knows” - Bruce Teele
Here’s an abridged recap of what everybody knows:
- The Fed is raising rates.
- Quantitative tightening (QT) hasn’t even begun yet.
- Inflation is still a big problem.
- Consumer confidence is at recessionary levels.
- US and China are likely entering recessions.
- Pretty much everything is in a downtrend.
I mean, you’d have to be NUTS to consider buying stocks in this environment, wouldn’t you?
Not so fast.
You see, when all the bad news is very well known and all that is being discussed in the media, the market inevitably gets to a point where everyone who wants to sell has already sold. Everyone who wants to hedge has already hedged their risk. And that is potentially where the stock market finds itself right now. Let’s look at the evidence that explains why this may be the case and explore some of the mechanics that can lead to a bear market rally.
Sentiment
Sentiment in this context simply refers to how people feel about the market. There are several places you can go to assess market sentiment.
For free online sources of sentiment, you can check out the following:
1) CNN’s Fear and Greed Index
Look, it’s a free indicator. It’s not going to time the market perfectly for you. It’s not going to make you a million dollars. But I do take note when this index reaches extremes. I avoid selling (or buying puts) when it’s showing an “Extreme Fear” reading, and I avoid buying (or buying calls) when the reading is “Extreme Greed”.
2) The American Association of Individual Investors Sentiment Survey (see chart below):
Notice how the recent block of bearish sentiment readings exceeds even the lows around the time of the Covid crash (red bars highlighted by the yellow oval)? Not something you would see near a stock market top.
Again, it’s far from perfect, but in my opinion, one ignores blocks of extreme bearish readings at their peril.
Positioning
How people feel can be telling, but is there a way to confirm that people who are feeling bearish are actually behaving bearish?
This is where we turn to one of my favourite market internals, the put/call ratio (PC ratio). The PC ratio measures how many put options are bought by market participants relative to call options. People buy puts when they think the market will fall; either to hedge existing stock exposure or profit from falling prices.
When the combined equity/index PC ratio surges higher and remains high, it reveals that “everybody” is buying puts. In other words, everyone is short/hedged. When everyone’s bearish and now short (as revealed by the PC ratio), there’s nobody left to sell. With nobody left to sell, the market runs out of downward pressure, and it takes very little to get the market drifting higher again.
The VIX
The VIX is heralded as the market’s “fear gauge” in the financial media. For anyone not familiar with the VIX, it is the most followed barometer of the market’s expectation of volatility over the next 30 days.
Stock market volatility has a strong inverse relationship with price. When the market falls, volatility – and the VIX –usually rises...usually.
This inverse relationship between price and volatility is how the VIX became the market’s de-facto gauge of fear and risk.
While the conventional way to interpret the VIX is as a “fear gauge”, in reality, all the VIX does is measure investors’ willingness to pay for hedging. When many market players get bearish, they become keen buyers of put options, which props up the VIX.
What was notable about the recent sell-off in the S&P 500 was how the VIX trended lower. Despite the S&P 500 falling 8.3% from 2nd May to the low on 20th May, the VIX moved from 32.3 to 29.4.
A VIX that isn’t surging higher during an 8% pullback is signalling a market where demand for puts isn’t there. Why would this be if the market is selling off aggressively? Well, remember back to the PC ratio. Everybody was already short!
SKEW
The other tell was a collapse in the SKEW Index. The CBOE SKEW Index is a barometer of tail risk in the S&P 500. A high SKEW indicates a market where participants are bidding up the price of put options that are more than two standard deviations out of the money (a “tail risk” event). When the SKEW collapses the way it did recently, it indicates participants are not concerned about “crash risk”. In this case, probably because they had already hedged it.
The VIX and the SKEW both pointed to a lack of hedging demand (”everybody” is already short).
Market Makers / Dealers
(NB - This section will get a little more technical. Please skip ahead if it’s too much!)
Remember that boatload of put options market participants bought (we saw this in the PC ratio)? Well, there’s something else that happens when everyone buys a boatload of puts.
On the other side of all those bought put transactions we discussed above are the market makers/dealers who sold the puts to market participants. The dealers are now short a boatload of puts. Being short a put option means you are effectively long stock. It’s a dealer’s job to hedge their directional risk. So, when they are selling puts (to the market), they need to short-sell stock (or stock index futures) at the delta-hedge ratio to hedge their directional exposure. This is why a powerful burst of put-buying can exacerbate downside moves in the market.
Options prices are very sensitive to changes in implied volatility. When options implied volatility drops (as indicated by the falling VIX), the value of options declines, all other factors equal.
Vanna Rally
Remember, dealers are holding a boatload of short puts, and those puts lose are now losing a lot of value. But these puts also lose delta. There is a second-order option Greek called Vanna, which quantifies the change in an option’s delta for a change in implied volatility. When implied volatility drops, the delta on the short puts market makers are holding will also drop. This means that to maintain their delta hedge; dealers will need to BUY BACK stock (or, more likely, stock index futures) they previously shorted to maintain their correct hedge ratio. In this way, dealer hedging activity can cause - or more likely amplify - a short squeeze in the market. The inside-baseball term for this type of rally is a “Vanna rally”.
Recession Risks
Recession talk has certainly been creeping back in, with the US recording a negative GDP print for the first quarter of 2022.
Yet consumer sentiment is already well within recessionary territory. Not something one would expect to see when unemployment is at a generation low of 3.6%:
These woeful consumer sentiment readings have been blamed mainly on inflation. Now, if the rate-of-change of inflation starts to decline (i.e. CPI remains elevated, but CPI prints start getting lower), it seems unlikely consumer sentiment will get any worse from here. In fact, it’s more likely to improve...at least until unemployment ticks up meaningfully.
Looking at the performance of growth stocks relative to value stocks this year, value has been the clear winner. Growth stocks have been derated to levels not justified by the current economic data.
The sectors showing the greatest early strength now are the high-beta sectors, including semiconductors, homebuilders, transports and consumer discretionary. This is another risk-on signal.
Technical Picture
We also have a near-perfect technical picture for a short squeeze.
At the low on 20th May, the S&P 500 undercut the previous low set on 12 May. A lot of traders like to buy breakouts and short breakdowns, so there will potentially be a large number of trapped shorts as a result of this false breakdown. A common area to place stops for such short trades is above the swing high recorded on 17 May. Guess what? The S&P 500 closed above this level on Friday 27 May, which will likely fuel further short-covering.
What’s different about THIS short squeeze?
It is fair to say that the stock market has had a couple of short-term short squeezes this year that have fizzled out very quickly. What makes this short-squeeze different from those others?
A couple of things. Firstly, the dollar has rolled over and lost momentum. When the USD is very strong, it’s a headwind for assets that are denominated in USD (like US stocks!) The past couple of attempted rallies by the stock market were in an environment of relentless dollar strength. This current rally is happening during a period of dollar weakness:
Secondly, bonds (specifically, 10-year Notes) look to have put in an important double-bottom against the 2018 low. Why might this be important? Because stocks and bonds have been moving in lockstep all year. If Treasuries can find a bid here, maybe stocks can too.
High yield (junk) bonds, too, are putting in a significant rally. Something that did not happen on prior rally attempts in the stock market this year. This is relevant because credit markets are much better at sniffing out danger than equity markets.
I made this comment on Twitter back in February:
I wouldn’t say that today’s chart has necessarily been “fixed”, but significant progress is being made:
Conclusion
I realise this note sets a relatively bullish tone, so I feel the need to clarify my expectations that this will prove to be a bear market rally. I do NOT think we have seen the final low for this bear campaign. I do NOT expect the stock market to rally to new all-time highs from here. But I DO think this rally has legs and will go further than many expect. Good trading!
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