One Of The Drivers In This Rally Is Running Out Of Gas

One Of The Drivers In This Rally Is Running Out Of Gas
Stéphane Renevier, CFA

over 1 year ago1 min

It’s been one of the pillars beneath the recent rally in stocks – the fact that so many investors have been squeezed out of their short positions and forced to buy stocks. But this support might be all but gone…

Many “fast money” investors – some hedge funds, for example – have been betting against stocks, building up significant short positions in the second quarter. So when stock prices began to rally in mid-June, a lot of them were forced to close their positions as prices went against them in what’s known as a “short squeeze”. And the more these investors closed their positions, the more the upward pressures that put on prices, leading to more investors having to close their positions – and leading prices to rally.

The chart’s blue bars show the fluctuation in short covering and short selling over the past 10 years, measuring their values based on how far they deviate from what’s typical – i.e. the mean, or the zero line here. The yellow arrow, to the far right, points to last week’s spike in short covering: at a Z-score of nearly three (or three standard deviations), it’s one of the biggest short-covering surges in the past decade. As you can see from the chart, these short-covering episodes tend to be brief. So while the surge may have supported markets over the past few weeks, it’s not likely to offer much support going forward. What’s more, if stocks begin to dip again, these same bearish investors might return to markets and go short again. And that would add brand-new downside pressure to those shares…

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