Stocks Just Reversed. Here’s Why.

Stocks Just Reversed. Here’s Why.
Stéphane Renevier, CFA

over 1 year ago3 mins

Stocks sharply sold off after yesterday’s inflation report dropped a less-than-stellar update, but then something strange happened: they reversed just as quickly to end the day a whopping 5% higher than their lows. So let’s get to the bottom of it: here are the main factors I think best explain the reversal.

Short covering: Investors already expected that stocks would tank if inflation came in higher than expected, and they hedged for that risk by buying put options and shorted stocks. So after inflation’s drop actually pushed stocks to dip almost 3%, many started to collect the profit from their hedges. This “short covering” – when short sellers become buyers and close their positions – pushed prices up, and pressed other short sellers to cover their own positions, in turn sending prices even higher. It won’t have helped that we’re in the last quarter of the year: fund managers who are up this year will want to crystallize any profit they’ve made, and those who are down are unwilling to start shorting at these levels.

Buying from chartists: Stocks were down about 50% from their post-Covid rally, which many chartists might’ve seen as a strong support level. And if chartists did take that chance to buy stocks at these levels, that could explain part of the bounceback.

Buying from rule-based strategies: Plenty of trades are made based on algorithms nowadays, and a big chunk of market volumes are purely driven by funds that rely entirely on predetermined rules. And while it’s hard to know exactly how those trades will have contributed to yesterday’s action, it is likely that they exacerbated the moves.

Fundamental factors: Earnings were better than expected yesterday, and rumors that the UK government might U-turn on its tax plans could have helped convince investors to buy the dip. Investors might also be thinking two steps ahead: inflation is a lagging indicator, and it should eventually fall as growth slows. So now that markets are pricing in higher-for-longer inflation, investors might be drawn to the risk-reward trade of betting on falling inflation and a Federal Reserve (the Fed) pivot. And while the inflation number was bad, the figure’s release at least removed some mounting uncertainty. And as the economic calendar looks relatively light for the next two weeks, some traders may have started to bet that the path of least resistance involves stocks rising higher.

So… what actually caused it?

No one really knows, that’s the truth of it. And anyone who claims to know is simply boasting a strong opinion – not a fact. The most likely explanation is that all the factors I mentioned – plus others that I don’t know about – played a part in the extreme price action.

After all, there’s data to support each camp. We saw a massive rebound in volume and a change in net positioning, which signals that short covering likely played a significant role. But we also saw that baskets of the most commonly shorted stocks mostly stayed in line with the broader market, while value and dividend stocks outperformed other stocks. On top of that, other assets like gold and bonds also posted a hefty reversal. That all suggests that fundamental factors – not technical ones – were probably behind lots of the drama.

But the most important question isn’t what caused the reversal, it’s whether anything has fundamentally changed for stocks. The short answer is probably not: core inflation is hotter than ever, the economy’s slowing, and the Fed is ready to go all guns blazing against inflation. So if anything, the circumstances for stocks are only getting worse. In the future, don’t assume a rally is a sign that the general environment’s improved: risks are still all around.



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