Massive Reversal
We are seeing wild trading sessions lately. Before the past 3 days, the main narrative had been that stocks did very little in the cash session. We would have between a 0.6% and 1.2% rally in the overnight futures session. Then, stocks would sell off slightly during the day, but stay green.
Once some of the euphoria was let out from this ramp, the situation changed. That’s not all bad news as the stock market opened down over 2% and rallied throughout the day on Monday. At one point in the AM futures session, the S&P 500 was down 3%.
The bottom was about 9:35AM when the market was down 2.4%. From the bottom to the close, stocks did well. There was a 3.4% rally from the bottom. Biggest jump was the 1.3% rally from 2PM to 2:20PM after the Fed announced it would buy individual corporate bonds. That wasn’t even news, but it was enough to push stocks higher.
It wouldn’t be surprising if in an alternative universe where the market fell, it ignored that news. Markets initially ignored the Fed’s stimulus announcement on March 22nd, but they rallied soon after.
Retail Traders and Hedge Funds Love This Market
Some technical traders think this reversal was a sign of strength. Of course, it was a sign of strength, but it doesn’t make me bullish. The stock market has been strong since May 13th besides the crash last Thursday. A problem is there has been too much strength. Investors are emotional. Parabolic trends don’t end well. Furthermore, valuations get stretched when stocks rally too much.
Retail traders love this stock market. They went from never trading stocks, to buying cruise lines. Many people, who don’t know what they are doing, are buying stocks. They should instead be buying index funds. If you don’t do the research, you will underperform.
Obviously, it’s fine to be a new trader. You can learn over time. Problem is these people want a quick buck. This isn’t a new trader trying to invest for a career. This is people who lost their jobs treating the stock market like a gambling app.
One of the key sparks to the fire that is retail trading is the decline in trading fees. As you can see from the chart above, the daily average trade and daily average trade per account has spiked. People put their stimulus checks into the stock market and are trading often. The more often inexperienced people trade, the more likely they are to make a mistake. This part of the market is hot money. That means it can move quickly. It jives with the latest volatile action in markets, however, retail traders can’t drive the market.
At most, retail traders impact the microcap bankrupt stocks that have spiked. Thousands of traders likely own Tesla stock. However, it’s so large that they don’t cause it to go up much. The fact that they are so exuberant about Tesla is a signal the stock might be too hot. By the way, Tesla stock rose 5.95% as it almost eclipsed $1,000 per share again. This stock is only down 3.33% from its record high. That Thursday correction didn’t take the euphoria out of the market.
Hedge funds are in love with this market just like retail traders. Watch what funds do, not what they say. It really doesn’t matter if someone says they are bearish if they are fully invested. They aren’t acting on their beliefs. One of the greatest signs of euphoria is apathy from the bears. It’s a very bad sign if people are bearish, but they still are long the market. They have given up having cash or shorting stocks.
As you can see from the chart above, hedge fund current net exposure to equity markets in June is the 3rd highest since 2006. They were more bullish prior to the 2018 mini bear market and at the end of 2006 which was about 1 year before stocks topped prior to the great financial crisis.
Some managers likely pulled back from stocks last Thursday, but that wasn’t enough. If stocks rally to that level again quickly, it shows us the bulls haven’t been pushed out of the market. Speculators are seemingly right back to betting on the market as if that decline never happened.
Record High Valuations
As you can see from the chart below, the fund manager valuation composite index shows fund managers think the stock market is more overvalued than at any point since at least 1998. This is a very bearish signal because fund managers thought stocks were overvalued before the COVID-19 recession. They thought stocks were overvalued before the January 2018 top. They also thought stocks were overvalued in 1998 and 1999 prior to the burst of the tech bubble.
Fund managers have a good track record of determining if stocks are expensive. However, this doesn’t stop them from getting long into big crashes. That’s why you fade what managers are doing, but you can listen to what they say about valuations.
Euphoric Monday
It was amazing to see euphoria in markets so soon after a 34% decline this year. Now we see euphoria right after Thursday’s crash. The market is still too frothy. On Monday the Nasdaq rose 1.43% and the Russell 2000 rose 2.3%. Shopify stock rose an outstanding 8.47%. It’s only down 2.39% from its record high. That correction did nothing to make people cautious. Investors love buying dips like we had on Monday morning.
Every single sector rose on Monday. Worst sector was healthcare which was up 18 basis points. 2 best sectors were the financials and consumer staples which rose 1.38% and 1.06%. CLOU cloud industry ETF had a monster day as it rose 3.01%. It’s now down just 1.51% from its record high.
With this type of euphoria in cloud stocks, you can’t have a 5% correction in which they rally to new highs a couple weeks later. Instead we need a massive 20% decline to stamp out the optimism.