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Why Dow Jones Bears May Unwittingly Launch the Stock Market Higher

Last Updated September 23, 2020 1:55 PM
Josiah Wilmoth
Last Updated September 23, 2020 1:55 PM
  • Major stock market benchmarks have rallied more than 30% off their late-March lows.
  • Yet short-interest in the S&P 500 remains remarkably high.
  • JPMorgan strategists believe short-sellers could launch the stock market higher – but what happens next?

It’s been called the “most hated Dow Jones rally ever.” But unfortunately for cranky stock market bears, strategists believe it might have more room to run.

S&P 500 Shorts Pile Up (Again)

Although major benchmarks like the Dow and S&P 500 have rocketed more than 30% off their lows, there’s a remarkable number of traders who are still betting that the stock market is about to tumble.

According to Bloomberg, short-interest in the SPDR S&P 500 ETF – one of the most popular ETFs among mom-and-pop investors – currently stands around 6.4%.

short the stock market
Stock market bears haven’t backed off their bets against this popular S&P 500 ETF, even after a historic April surge. | Source: Bloomberg 

This means that despite April’s massive stock market rally – which was aided by a robust short squeeze – short-interest in SPY has only ebbed moderately  from the near-record of 7.4% it hit on March 3. It had ranged below 1.5% as recently as January.

And as noted by Charles Schwab Chief Investment Strategist Liz Ann Sonders, hedge funds have hiked their net short positions in S&P 500 futures  to the highest level in five years.

Short-interest in S&P 500, stock market
Source: Twitter 

At first blush, the average investor might see that as a bearish signal for the stock market. After all, isn’t it a bad sign that so many traders are positioning themselves to profit when the S&P 500 falls?

Why a Short-Selling Spike Could Send the Stock Market Higher

Not according to JPMorgan strategists. They view it as one potential catalyst  that could propel the stock market even higher.

“We still find room for further short-covering,” strategists led by Nikolaos Panigirtzoglou wrote. “There is enough short base to propel risky markets further from here, in particular equities and HY credit.”

Here’s why: Somewhat counterintuitively, short-selling is arguably a net positive for stock market pricing.

That’s apparent enough when a price increase triggers a short squeeze. But as Alphaville’s Jamie Powell recently explained, short selling creates a floor for the stock market  when it does plunge.

[S]hort selling is a net positive for markets as it provides a floor on for equity prices. Indeed, perhaps counter-intuitively, they tend to be net buyers when share prices fall.

It’s one thing to book a profit on paper when you short a stock. But if you actually want to realize those profits, you have to buy back the shares you originally sold short and return them to your lender. This is called covering your position , and it turns bears into buyers.

If there’s enough short-covering on a heavily shorted stock, it can quickly turn into a short squeeze that causes the price to rocket off its low.

Where Does the Stock Market Go Next?

dow, djia, stock market, S&P 500
Short-covering helped the Dow and S&P 500 rocket off their lows, but JPMorgan strategists believe there’s plenty of short-interest left to power the next leg of the recovery. | Source: Yahoo Finance 

There was plenty of short-covering after the Dow Jones suffered its quickest-ever descent into a bear market. It’s one of the reasons April proved to be the stock market’s best month in 33 years .

That’s why it’s surprising to still see so much short-interest in its fellow benchmark, because it suggests there’s still plenty of dry powder left to ignite the next stage of the rally.

But there’s a catch. A short-covering rally can only take the stock market so far . Eventually, short-interest will dry up, and the S&P 500 will have to stand on its own.

That’s when we’ll find out whether this is a genuine stock market recovery or nothing more than the “bear market rally” that skeptics claim it is.

Disclaimer: The opinions in this article do not represent investment or trading advice from CCN.com. Unless otherwise noted, the author has no position in any of the stocks mentioned.