Stocks ripped higher today as the market recovered from Friday’s big selloff. The Dow, S&P, and Nasdaq Composite all gained aggressively following stronger-than-expected bank earnings.
JPMorgan (NYSE: JPM) reported robust earnings on Friday opposite Citi (NYSE: C), which had issues last quarter. Morgan Stanley (NYSE: MS) reported a miss of its own.
But Bank of America (NYSE: BAC) brought banks back on track today after reporting blowout trading revenue and net interest income, the latter of which hit a 10-year high thanks to the Fed’s recent rate hikes.
BAC shares opened over 5% higher this morning as a result.
But will the good times continue? It likely depends on whether the Fed will continue to hike rates or not. And, if the Fed sticks to its guns, will bank stocks manage to rise amid a broader market slump?
These questions (and more) will be answered in the coming months as the market enters a seasonally bullish time of year.
But today’s rally had less to do with BAC earnings than it did with the overabundance of shorts that were put on last week by hedge funds.
Goldman Sachs flow trader John Flood detailed just how intense the shorting got in anticipation of a bad Consumer Price Index release.
“Update from GS PB yesterday tells you exactly what went on today […] As US stocks tested YTD lows, the pace of net selling from hedge funds accelerated with the overall Prime book seeing the largest notional net selling since mid-September (-1.7 SDs 1-year), driven by short sales outpacing long buys ~5 to 1,” Flood wrote in a note to clients.
“In notional terms, Tuesday’s short sales were the largest in the past month and ranks in the 97th percentile vs. the past year.”
Goldman’s Prime Desk released a follow-up note after Friday’s bloodbath.
“The overall Prime book saw the largest notional net selling in 4 months (-2.1 SDs), driven by short sales outpacing long buys nearly 5 to 1 – this week’s notional short sales ranks in the 94th percentile vs. the past year,” the note read.
In other words, plenty of “kindling” for a Monday short squeeze was out there over the weekend. Hedge funds scrambled to cover their shorts today, applying massive bullish pressure shortly after the market opened.
That’s why stocks erupted today.
But it also suggests that this session’s gains may not last. Remember that similar positioning last week caused an improbable post-CPI reversal that saw the S&P swing roughly 4.7% from where opened to where it closed. Then, stocks collapsed again on Friday as the shorts came back on.
Does a similar fate await the market this time around? It certainly could. Low liquidity and kneejerk reactions from hedge funds have only intensified the recent volatility. More is to be expected unless stocks can build on today’s progress.
“Despite the increased risks to growth and the rise in volatility, equity markets have neither become cheaper relative to bonds, nor yet priced in a material slowdown in growth and earnings,” said UBS chief investment officer Mark Haefele.
And so, despite today’s impressive gains, traders should remain very cautious about leaning bullish again. Tomorrow could easily be a repeat of Friday as hedge fund shorts wipe out dip-buying bulls like they did last week.
