Why is 2023 rallying?
A look into this bull market
Last week, we took a look at analyst warnings and some risks of this market that kept going up. Macro context is clear and the Fed will stay on his route “higher for longer”.
Today, we are looking at some reasons of the January rallying. Is it going up because people want to buy? Are algos playing an important part?
Short covering mania
Are investors real buyers or are they forced to buy?
A lot of the equity that guided the S&P 500 in January has been pushed by huge short covering. Last week, Hedge funds rushed to unwind bets on falling markets as stocks surge.
After Fed hints of a more dovish route (even if Powell just reminded the objective to reduce inflation), speculators forced the funds that were poorly positioned for the rebound to limit their losses. According to Goldman Sachs, this was the largest buy back of stocks since November 2015. So, the Nasdaq index jumped 3.3% and SPX 1.5%.
Natixis is writing:
“It is hard to fight the risk-on momentum. The market remains focused and reassured by the near end of the [interest rate] tightening cycle... Retail/meme stocks are outperforming strongly”.
Zeygos research analysed the performances of the stocks with the highest short interest level. They found out that the top 50 of this list registered an average performance in 2023 of +28% (x3.5 mkt performance). Best 250 averaged 15%, something less than half of what S&P 500 did since the start of this year. In detail, these are the top names:
Seems pretty clear that short covering highly influenced the performance of the market until now. A panic buying of these stocks helps to explain a 5% of the entire market.
Moreover, Hedge funds, heading into 2023 with low equity exposure, are scrambling to unwind short positions as January’s equity rally defied warnings from prognosticators at firms like Morgan Stanley and JPMorgan that the going will get tough in the first half. Amid the Nasdaq 100’s best start to a year in two decades, funds tracked by Goldman quickly slashed their bearish bets in technology shares, with short covering hitting the fastest pace in two years, data compiled by the team including Vincent Lin show.
Such covering may have added fuel to the market rally, luring more investors to join the party. Rules-based computer-driven funds such as trend followers, for instance, have gobbled up US$ 95bn to US$ 100bn of stocks this year, with January’s purchases marking the heaviest since November 2019, according to an estimate from Morgan Stanley’s trading desk.
This effect has been also enhanced by risk reversal option strategies being forced to be closed: funds have to buy calls and sell their puts.
Bespoke Investment Group: Breaking down the Russell 1,000 index into deciles based on which stocks have the highest levels of short interest shows that the top performers have also been those which have been most heavily bet against by investors. Whereas the decile of stocks with the lowest levels of short interest has risen a mere 4.4%, the decile of most heavily shorted names is up a substantial 36.3%. An equal-weight index of the 100 most highly shorted Russell 3000 stocks shows that the group has rallied almost 30% over the past month.
Last but not least, we even have a massive stock buyback. In January, companies announced buybacks for over US$ 131bn (the highest ever start to a year). Great part of the amount come from Chevron, that pledged US$ 75bn for share buybacks as cash grows; still, the number is impressive.
It was a perfect storm of buying with the technical demand profile being very supportive.
Equity and cross asset volatility has reset lower triggering demand. The systematic community has now bought around US$ 125bn of global equities in the last month.
The non fundamental demand has been exacerbated with corporates continuing to do buy backs.
The Long short community has suffered with Thursday seeing a 99.9th %ile move in terms of de-grossing via selling of longs and covering of shorts. In fact momentum had a 3 standard deviation move on Thursday.
Retail was out in force last week (partly manifested by the record amount of call options).
How about macro context?
While analysts are cutting recession expectations due to the strong labour market and early signs of improvement in the business surveys (like GS said they cut forecast US economy will enter a recession in the next 12 months from 35% to 25%), bond market has gone from doubting the Federal Reserve to falling perfectly in line with the US central bank’s projection for a peak in interest rates north of 5% later this year.
Macro Alf reminded that in 2019, the Fed pivoted hard and the economy managed a proverbial soft landing. The 2018 hiking cycle which Powell abruptly reversed with his early 2019 pivot slowed the economy down, but not nearly enough to result in a hard landing.
The S&P 500 earnings growth was +0.6% (not negative), core inflation was stable around 2% and the US added 160k new jobs per month: low nominal growth, but not a recession – in other words, a soft landing.
Now, core inflation is declining (volatile), wages are dropping (but recently are growing, outpacing inflation) and the pace of hiring is slowing. More interesting, the EPS growth is still negative, as noted by Morgan Stanley:
“While we didn't get the definitive reversal we were expecting, the door is still very much open for our call to play out; though it could develop at a bit slower pace. Forward EPS growth has just gone negative, earnings recession is not priced”.
JP Morgan is also summarizing the tug of war pretty well saying that some of the equity market supports (peaking bond yields, China reopening, lower European gas prices) are not exhausted, but a lot has repriced. Interest rates and crisis are not a news anymore.
"We argued that supportive seasonals at the start of the year and light positioning would still be helping as we move through Q1, but positioning is quickly normalizing. Sentiment was very downbeat 6 months ago; now investors are more comfortable chasing the market. Crucially, we think the fundamental confirmation for the next leg of the rally will end up lacking, consequently Q1 will likely mark a high-water mark for the market".
Finally, it seems FOMO is spreading in investors, gripping credit markets and making bond premiums vanish. Some companies are starting to see money being thrown around in ways that feel very similar to the easy-money days and are raising cash in debt (deepening on this matter on Bloomberg). Be careful: the short process is almost over. Tactical indicators suggest the short squeeze has likely fully played out. S&P cumulative flows are back to high conviction sell levels that we saw in April and August 2022. Don’t take this “bull market” for granted.
great take, thank you! ... short covering and looser financial conditions ... rally. Have a great day!