Pushing Them to the Limit

This is a different kind of torture for the underinvested:  seeing others make money (fully invested) while making nothing (in cash) or losing (being short).  Its not a fun place to be, its almost as bad as losing your ass with the crowd as the market plunges.  

The COT data on Friday is not good news for the shorts.  The speculator short positions grew even larger, these are massive short positions that will take weeks to unwind, so that is a big thorn in the side of the bears.  I am assuming that after the CPI number on Wednesday, you got a lot of short covering afterwards going into Friday, so the number should be quite a bit lower next week, but specs will still be quite short.  

The worrying part about the huge spec short position is that they are deep underwater, and close to the stop out point, which could usher in even more short covering in the days ahead.  This has nothing to do with fundamentals, but pure positioning and money flows, which favor the bulls here, despite a huge rally of over 600 SPX points in less than 2 months.  

There are 2 instances of large spec short positions while the market was ripping higher off an deeply oversold bottom, 2015 and 2020.  After a huge rip higher in October 2015, you had a 50 day consolidation from November to December 2015, during which shorts covered, before plunging again to new lows in January 2016.  In May 2020, after a huge rip higher, you didn't see shorts cover for several months as the market grinded and higher, grinding the shorts to dust and making new all time highs during the process.  

A sample size of 2 is not big enough to draw huge conclusions, but the liquidity conditions now are more similar to fall 2015 than spring 2020.  In December 2015, the Fed had its first rate hike in over 9 years, while in the spring of 2020, the Fed was embarking on bazooka QE while maintaining ZIRP.  The key will be to see how much short covering we get in the weeks ahead.  The more short covering you see in the COT data, the better the setup gets for the bears.  If however the bears remain stubbornly short like in 2020, then you could see a grind higher for much longer than most expect despite the poor liquidity conditions.  

If there is one thing I've learned over the years, its the importance of positioning in increasing or decreasing the probability of a trade.  The less popular my position is among the speculator community, the higher the win probability, especially for longer time frames.  

The bottom line is this:  everyone knows that the liquidity conditions are unfavorable for stocks, with Fed tightening into an economic slowdown, but the light positioning reflects this reality.  Everyone is focused on the Fed, and not focused enough on the economy, which is much weaker than the stock market is pricing in.  Will the economic weakness be big enough to overwhelm the light positioning and force retail investors (still high equity allocations historically) to dump their stocks as we see more earnings warnings in the coming month?  I give that a high probability of happening, but you probably need to see shorts cover first before you see that big move lower.  

The marginal buyer or seller is what moves the market.  There has been a lot of short covering this week, which has increased the net positioning of hedge funds, but the question is will they put on shorts again as the economy weakens or will they add to their low long exposure and cause a chase for performance as the market grinds higher?  It is a reflexive situation here.  I don't expect hedge funds to aggressively buy dips if the economy gets really weak, leading to mass earnings warnings, which likely leads to a retest of the June lows.  If the economy holds up for the next couple of months and Q3-Q4 earnings meet expectations, while the 10 year yield stays under 3%, you are likely to see a chase for performance and a grind higher to SPX 4600-4700.  

The difficulty in markets these days is that investors rightly focus on liquidity conditions when determining whether to get bullish or bearish, which makes everyone follow the same gameplan.  This leads to crowded positioning when the Fed is very loose (lot of bulls) and when the Fed is very tight (lot of bears).  Even 2 years ago, it wasn't like this, as the Fed was very loose, yet you still had a lot of bears.  Investors have learned their lesson over the years, and it is to not fight the Fed.  That leads to the widespread skepticism you are seeing about this so-called bear market rally.  It causes the market to trade in ways that seem irrational and manipulated, but its just because too many are leaning in one direction (short) and have to stop out of their positions as the losses get too big for comfort.  This is what has happened since the CPI release, and was the number 1 reason I waited till after the CPI came out before embarking on a short campaign, due to the crowded short positioning near the edge of getting stopped out.  

In the short term, the past few days squeeze higher looks like a blowoff top inducing massive short covering.  According to Goldman PB data, it was one of the fastest pace of short covers in the past decade:

This is one piece of news that finally shows that the pain has gotten too great for a lot of funds and they are cutting and running.  This is what I want to see more of to gain confidence on the short side.  Just a neutral level of positioning in this liquidity and valuation environment would present a high probability short setup for SPX and NDX shorts.  As of now, its a favorable risk/reward on the short side, but not high probability setup yet.  More data confirming lots of net buying (prime broker, COT, options) would generate a near can't miss shorting opportunity.   

Due to the speed of the up move and the heavier call buying activity in popular single name stocks (TSLA, AAPL, AMZN, MSFT), I put on a short NDX position on Friday with plans to add to it if I see more data coming in that's favorable for the bears.  

Its a tough time for bears as this is near ideal fundamental conditions for a big leg down, but its a crowded trade, and that makes the destination that much more difficult to arrive at as many shorts are in quite a bit of pain and at their wit's end, close to throwing in the towel, if they didn't late last week.  Hopefully, I won't be one of them!