Pity the investors on the wrong side of this market. There are still plenty of them out there.
As North American stocks have staged a remarkable recovery over the past few months, speculators have increased their short positions on U.S. equities to record highs. Short interest on S&P/TSX Composite Index stocks has barely budged since peaking around the same time the market bottomed out.
Betting against markets that are now up by more than 40 per cent has been a distinctly painful trade for short sellers and hedge funds. The past week may have finally broken their will.
There are early signs of a mass unwinding of short positions, as growing evidence of an economic resurgence propels equities toward their prepandemic peaks.
“If we were to see new highs, that could be the trigger for a monster short-covering rally,” said Martin Roberge, a portfolio strategist and quantitative analyst at Canaccord Genuity.
Short sellers typically arrive early to a new bull run. After a major financial shock, such as the one that sent stocks into freefall in February and March, short covering tends to fuel the initial stages of a rebound.
Closing out a short position involves buying back the shorted securities, which puts upward pressure on prices. Enough investors following suit can elevate the entire market.
This time around, however, bearish bets on U.S. stocks kept rising through the month of May, as stock benchmarks steadily gained strength. Toward the end of the month, total short positions on U.S. equity futures hit a record high of US$275-billion, according to data compiled by Mr. Roberge.
Short-covering activity also didn’t materialize in any substantial way in Canada, as it has in the past. Aggregate short interest on S&P/TSX Composite Index stocks stood at 1.4 billion shares in late May, which was just 5 per cent off its March peak.
Many large investors have evidently been reluctant to believe that the revival of stocks, which has unfolded with dizzying speed, is sustainable.
“It reflects the great disconnect between the market and the economy and investors speculating on a narrowing of that gap,” Mr. Roberge said. “So far it hasn't worked.”
The bear case for stocks has hinged on two key risks. The first is the severity of the economic damage wrought by the pandemic, which triggered depression-level job losses and contractions in GDP. And second is the lack of breadth in the market rally, which early on was driven by a relatively small group of growth stocks, such as the U.S. tech giants.
But on both counts, the danger seems to have subsided in recent days. Since mid-May, a broad upswing has taken hold across the U.S. stock market, with laggards closing the gap with leaders.
In addition, the gradual reactivation of economies seems to be moving quicker than anticipated. Labour markets in Canada and the U.S. now appear to have moved past the mass-layoff stage, catching economists by surprise with jobs added in both economies in May.
Those employment reports on Friday sparked another big move higher in stock indexes, bringing the total gains from the market bottom to 43 per cent for the S&P 500 index and 41 per cent for the S&P/TSX Composite Index.
The bear case for revisiting the March lows is getting weaker by the day.
“Is this a legitimate bull market? I think we have to be open-minded to that because this has gone way too far to be just a bear-market rally,” said Jason Mann, chief investment officer at Toronto-based Edgehill Partners.
There are some signs that bearish speculators are finally starting to succumb to the market rally. The past week, in particular, has seen a rotation into the stocks that were hardest hit in the selloff, many of which would be classic candidates for hedge funds to short.
The Dow Jones U.S. Airlines Index, for example, gained 35 per cent over just the past week. U.S. cruise-line stocks were up by between 15 and 20 per cent on Friday alone.
Investor enthusiasm for the stock market’s biggest casualties of the pandemic could be an indication of short sellers relenting. Data released early next week will show if short positioning has started to decline.
“If it has, we are probably witnessing the early innings of a short-covering rally,” Mr. Roberge said. And if that’s the case, the stock-market rally just got itself another source of fuel.
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