More short-covering rally potential ahead

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paul campbell

A long-awaited round of short hedging is underway in the US equity market, supported by several key technical indications. More importantly, next week’s Fed policy meeting could provide the fuel for an even larger and more extended short-covering round.

True to form, stocks have surprised the consensus by bouncing back in the face of near-universal bearish sentiment from retail investors. In fact, talk of the economic downturn in the mainstream media has recently reached levels not seen since the depths of the 2008-2009 credit crunch.

A buildup of bearish sentiment, coupled with near-record levels of put option buying among retail option traders, created the conditions for a rally higher. According to SentimenTrader’s Jason Goepfert, his proprietary model of panic/euphoria recently fell to one of the lowest levels in nearly 30 years (ie, into “panic” territory).

The model is based on extreme behaviors of options traders and, as you can see here, it has signaled a major low point in the stock market every time it has reached current levels in the last few decades.

Euphria/Panic Model

Sentiment Trader

Jason notes that sentiment levels are similar to October 2008, which was not the final bear market low. However, it served as the proverbial “beginning of the end,” as stocks reached their final low soon after. Panic-like positioning by option traders also suggests that there is likely to be limited downside ahead and much higher upside in the coming weeks.

Meanwhile, the volatility index (VIX) is rapidly declining and is close to falling below the psychologically significant 25 level. Historically, the market environment for buying stocks is much healthier when the VIX is below 25 and trending lower.

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CBOE Volatility Index

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But in what could be the biggest catalyst for a future stock market rally, central banks around the world are now showing signs of easing tight monetary policies that have been a major drag on stocks.

Just this week, the Bank of Canada surprised the market when it announced an interest rate hike below consensus. The Bank further indicated that it “was nearing the end of its historic tightening campaign as it forecast that the economy would stagnate for the next three quarters,” according to Reuters.

Wall Street has been conditioned by the Federal Reserve to expect a 75 basis point federal funds rate hike at the November FOMC meeting. In fact, the CME FedWatch Tool, traders have assigned an 82% chance that the Fed will raise rates by 0.75% at the November meeting. Assuming it does, this would be the fourth time in a row that the central bank has raised rates by this amount.

However, if the Bank of Canada’s recent policy reversal is any indication, there is a possibility that the Fed will decide to “pivot” and, instead of raising rates by 75 basis points, raise them by a smaller amount (50 basis points). basics, for example). This would almost certainly provide an additional short-covering catalyst for the market and set up the November-December rally that is so typical of a post-midterm election.

(Supporting the Fed’s pivot scenario, San Francisco Fed President Mary Daly expressed her view that slowing the pace of interest rate increases “will help preserve market structure,” while St. Louis Fed President Bullard said he wants the Fed to “get a deflationary process underway in 2023.”)

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What’s more, the data above shows that midterm elections tend to be major turning points for the stock market, regardless of which party wins. According to Stockbroker’s Almanac author Jeff Hirsch, “midterm election Years are typically volatile for stocks as Republicans and Democrats vie for control of Congress, especially under new presidents.

Hirsch also noted that bear markets tend to bottom in October, and specifically around the end of October in the second year of a new Democratic president’s term, before rising in November and December, as illustrated in the chart below.

Historical stock trend after the midterm election

Stockbroker’s Almanac

A final consideration is technical improvement in the oversold small-cap segment of the stock market. The chart below shows the 4-week rate of change (momentum) of the number of Russell 2000 shares making 52-week highs minus lows. This is my favorite measure of how much internal momentum the market has, and right now it shows that the bulls have an excellent opportunity to rally small-cap stocks in the short term.

Russell 2000 New Momentum Highs and Lows

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Additionally, based on historical data, the main sectors that tend to outperform the S&P during the months following a midterm election are the materials, technology, industrials, healthcare, and consumer discretionary sectors.

In conclusion, the pieces are lining up for what looks to be a vibrant fourth quarter performance in the broad equity market. A prolonged relief rally is long overdue, especially given the dramatically “oversold” nature of equities in most sectors in recent months, and we are entering what has historically proven to be a bullish period for equities. . As a result, I am looking at buying opportunities in individual stocks for the first time in a long time, with a particular focus on the materials and consumer staples sectors.

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