As many of you already know, since the beginning of the year the stock market (which we will define as the S&P 500) has been steadily rising. In fact, the S&P 500 and Nasdaq have been the laggards. The Russell 2000 (small cap index) continues to carve out new all-time highs almost daily, and the Dow Jones Industrials are not far behind. This buying stampede has even the staunchest of bears throwing up the proverbial white flag conceding that shorting the market is more painful than it’s worth. Many of this ilk are beginning to subscribe to the old saying “if you can’t beat’ em, join’ em” which infers that they shouldn’t fight something that’s unwinnable. History has shown us that this type of sentiment usually occurs at the tail end of market rallies, not when they are just starting. Ironically, market rallies usually start when everyone has sold and is very bearish.
Conventional thinking would have us believing that since everyone is bullish—implying that most are buyers — that this activity would act as fuel to propel higher prices. To some degree this is true, for a time; however there is a point when most of the buying has taken place. This typically happens when market participants are the most bullish which often results in market corrections. If you think about how the markets really work this would make sense. First, after a protracted up move in the market, traders that have participated on the long side have mostly profits to show for their efforts, this in turn increases their appetite for risk. In other words, many of these traders are willing to take on much bigger risks. This can mean bigger share size, more leverage, and not placing stops. And as the markets head higher, this penchant for risk commensurately increases. It’s almost like a feeding frenzy, where greed clouds logical thinking. Unfortunately, when the party ends it usually doesn’t end well.
The reality is that when a trader goes long the market he is part of the demand driving prices higher, but at some point, this same trader will have to exit his long position. The reasons for exiting may vary from getting stopped out, fear of losing profits, or he may have a predetermined profit objective that is met. Whatever the reason, when this trader sells, he is now putting new supply onto the market. If there are more seller orders than those to buy the simple equation of supply and demand takes hold and the market has to fall. Stated another way: when there are massive long positions in a market that want to sell when the buyers run out, supply will overwhelm demand because the interest to buy diminishes dramatically, often times resulting in a rapid reversal.
On Wall Street, when a stock or a futures market goes up in a rapid fashion, we refer to this as a “crowded trade” because of the dynamic explained earlier. If you’ve ever seen a market rise quickly sometimes known as a parabolic move, you probably recall a violent retracement. Understanding this market dynamic is important, because if you don’t, you will fall prey to being one of the last buyers in the rally, and then when you want to sell, who will be there to sell to? Think about that next time you feel the urge to chase price.
So in closing, is too much bullishness good for short sellers? The answer is yes, if we can spot where the sell orders will outstrip the buy orders. And yes, we can spot this imbalance on a price chart if we know what that picture looks like, and if we know whom we are trading against.
So until next time, I hope everyone has a great week.