During the past couple of weeks, my message has been that many sentiment indicators we track, are displaying levels of optimism that have historically made stocks vulnerable to pullbacks. Or, at best, vulnerable to a period of underperformance.
Whether you are looking at the actions of equity options buyers, active investment managers’ exposure, the opinions of newsletter advisors and retail investors, or how large speculators are positioned on future volatility, you will see growing optimism prevalent. However, I have also noted that price action in major equity benchmarks has not given these bullish market participants reason to unwind bullish bets and, as such, bulls should stay the course.
“Jim Chanos has been short Tesla Inc.’s stock for five long years. And although he’s reduced the size of the trade, he’s not done with it yet… While he said it’s easier than ever to find companies that look attractive to short, many bearish bets are just not working. The firm is usually correct on about two-thirds of its picks, but only one-third of its shorts are currently panning out.”
- Bloomberg, Dec. 3, 2020
In fact, per the excerpt above, the price action in equities has produced increasing pain for those that bet against stocks by shorting equities. The rally in Tesla (TSLA) is just a microcosm for what the shorts are experiencing overall. As you can see in the chart below, as the market has gone north, short interest has gone south, as the shorts are forced to reduce position size or abandon their bets against individual stocks entirely.
The chart immediately below displays total short interest on S&P 500 Index (SPX -- 3,699.12) components with an SPX overlay. As a side note, Tesla (TSLA) will become a component of the SPX in two weeks and, as such, TSLA’s price action or the short covering going on in that stock is not yet reflected in the chart.
On one hand, the short covering represents demand for stocks and is coincidentally bullish. However, as total short interest decreases, it represents less future buying power, which eventually becomes a risk for bulls.
“There is good news on the sentiment front… That is, the $192 billion that moved out of domestic equity funds in the first half of 2020 represents future buying power…But there will likely be a point they move off the sidelines and back into equities. It is the timing that is uncertain, especially as the trend in this group through June’s data is reducing equity exposure. They may be looking for COVID-19 and/or election uncertainties to alleviate.”
- Monday Morning Outlook, Aug. 10, 2020
“Mutual fund participants … continued to move out of equity funds. While they represent future buying power, the unknown is exactly what it would take to give them confidence to buy stocks.”
- Monday Morning Outlook, Sept. 14, 2020
“ETFs tracking stocks pulled in a record $81 billion, compared with $17 billion for their fixed-income counterparts. The flows come as equities worldwide posted their largest monthly advance since 1988.”
- Bloomberg, Dec. 4, 2020
On Friday, the excerpt above from Bloomberg news caught my eye. While I do not know the exact types of equity exchange-traded funds (ETFs) were being used to calculate the $81 billion figure, the statistic reminded me of observations that I made in August and September, regarding potential sideline money that could eventually flow into the market.
I remember distinctly noting that after months of significant net outflows when observing both domestic ETFs and traditional mutual funds, the timing of such a move was uncertain, but I speculated that perhaps election and/or Covid-19 uncertainties could be the catalyst(s).
The graph immediately below highlights that there has been a considerable let up in the massive net outflows, which was the result of a huge pick up in the inflows of exchange traded funds that helped offset the continued outflow from traditional mutual funds. In prior months, the ETF inflow was not nearly enough to offset the regular outflow from traditional domestic equity mutual funds, creating a headwind.
I find it interesting that on the heels of positive vaccine news and the removal of election uncertainty last month, the massive outflow headwind was eliminated and stocks were able to break into new high territory as other market participants grew more bullish. Note that in the six months prior to November, domestic ETF inflows were small relative to prior months.
The unknown is whether those holding traditional mutual funds are moving into the ETF world, which would imply that the net outflows will continue for months and maybe years to come. One possibility is that traditional fund players moved into cash before the election and vaccine news, and in turn began deploying money into the ETF world as these uncertainties faded and stocks rallied.
According to ETF.com, the SPDR S&P 500 ETF Trust (SPY -- 369.85) was the recipient of the lion’s share of November’s ETF inflows, outpacing the tech-heavy Invesco QQQ Trust Series ETF (QQQ -- 305.52).
Digging into the daily data revealed that a major inflow occurred on November 10, the day after the first of multiple positive headlines occurred on a vaccine for Covid-19. The second largest inflow into the SPY during the month of November was the day after the Nov. 3 election.
I point out the fund flow data because we now know there was a change in sentiment among ETF traders in the month of September. And to the extent that their actions represented others, by applying a 20-day moving average of the SPX closing data during the month of November, we can gauge roughly when the “wait and see” money came into the market, in order to estimate their breakeven level.
As of the end of November, the SPX’s 20-day moving average was at 3,548, which is just below the September peak at 3,580 and just below 3,553, which represents the level that coincides with the round 10% year-to-date gain on the SPX, which was a “profit-taking” level in September and October.
Therefore, if you are looking for an area that the SPX might have to move below before risk grows of an unwind of the growing enthusiasm we are seeing at present, I think the 3,550-3,580 area is a good starting point.
My message remains the same as prior weeks. Do not disturb long positions, as the trend is your friend and market enthusiasts have been given no reason to panic. But with the CBOE Market Volatility Index (VIX -- 20.79) at four-month lows, you could hedge long positions in recognition of the sentiment-based risk.
Todd Salamone is Schaeffer's Senior V.P. of Research
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