Massive short covering? Market is getting ready for new growth

Hedge funds remain net short on stocks, while individual investors are starting to reduce their allocations.

This increases the risk of a mass short position closure if the market continues to rise.

“Dead cat bounce” or a jump to new highs – the decision moment arrives for those who have shorted or underallocated in stocks. It still seems that there are a few “bears” who need to make this difficult choice – and by doing so, they will contribute to the market’s upward momentum.

Hedge funds overall still seem to have weak or negative sensitivity to the S&P 500 index. Clearly, this indicator lags in nature but coincides with other banking data showing that hedge funds and CTAs have been in short positions. For the latter, we can use the DBi Managed Futures ETF as a confirmation indicator – it holds a short position in U.S. stocks, although this short position has shrunk in recent weeks.

The positioning of speculators from the Commitment of Traders report shows a net short position in S&P futures.

Speculators are also net short on mid- and small-cap stocks, although they have net long positions in Dow and Nasdaq futures – the latter likely driven by the weaker performance of tech stocks, followed by their current outperformance.

Nevertheless, given the size of the S&P index and the fact that its futures have the highest open interest, the short position there reflects the overall exposure to stocks (as of Tuesday last week).

Individual investors remain firmly bullish during the decline, even if emotionally they have already turned bearish.

The “Bulls vs. Bears” sentiment index from the American Association of Individual Investors remains deeply in negative territory.

At the beginning, however, individual investors’ allocations to stocks did not decrease in line with their bearish sentiment, but now they are starting to decline.

Whether this is the wrong move or not – it will soon become clear. But in the interim, it represents yet another potential source of buying, should the fear of missing out (FOMO) start to appear – especially if hedge funds broadly exit their short positions (as many of them are likely already doing).