Don’t Believe the Fearmongering: Stocks Are Headed Higher
Speculator short positioning in stocks has reached an extreme. They're all piled into the same negative bets. Before long, those same investors will rush for the exit, creating a scramble to buy back stock.
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Professional investors are overwhelmingly positioned for a stock market collapse… and often, when too many investors – even if it’s the so-called “smart money” – are all piled into the same side of a trade, that means that prices are most likely headed in the opposite direction.
In finance, there’s a concept known as the greater fool theory. It’s when investors buy an asset that’s already highly valued, in the hope that they’ll find someone else – the “greater fool” – to sell it to.
It works… until it doesn’t… that is, until the music stops and there’s no one to sell to, because everyone who’s going to buy has already bought (or: because a speculative bubble has popped). That’s when asset prices collapse.
Greater fools are just as prevalent in the institutional investing arena, as they are among regular folks putting their money into the market. Just like retail investors, asset managers can also get emotionally invested… and drag their colleagues – fellow fund managers – into the morass of chasing assets.
Of course, it can work the other way, as well: Way too many people can be short the market, or a stock (if you’re short an asset, it means that you’re betting the price will decline). And the unwinding of that scenario is when prices rise sharply, because eventually there’s no one else to sell short. Since professional investors often employ leverage, the consequent selloff or short cover rally, depending on their positioning, can be even more sharp.
Right now, hedge fund managers have built up a huge short in the S&P 500. That means they think the market will fall.
But what this tells us is that instead, stocks are actually headed higher…
Identify the Target
The Commodity Futures Trading Commission’s (“CFTC”) Commitment of Traders (“COT”) report shows professional investor positioning. The data’s published every Friday afternoon. It details the total number of contracts held by market participants (“open interest”) for futures and options on domestic futures exchanges.
The information is an easy way to assess current institutional investor sentiment and trends. We can see this by looking at whether they’re buying, selling, or shorting futures contracts. In other words, are those bets increasing in number, or declining? Because, if positions are increasingly positive, sentiment is rising. And if bets are dropping, sentiment is fading, or going negative.
To see what we mean, take a look at the following chart from the CFTC of S&P 500 Index net total futures positions…
The data sums the total amount of open interest in S&P 500 futures contracts for both “commercial” and “non-commercial” investors (more below on that distinction) on a long and short basis. So, it’s subtracting the total obligations to sell from those to purchase, to derive a net position number.
If we were to see that position number hit say 150,000 – like in June 2009, in the graph above – it would imply extreme optimism while a position of, say negative 317,000 – like in March 2007 – would signal huge pessimism. The above chart shows investors are currently net long 15,573 contracts. That’s roughly neutral.
But this data only tells part of the story. And there’s a more important signal we want to follow…
Understanding the Data Trail
The CFTC tracks these numbers on both a “commercial” and “non-commercial” basis. The commercial figures represent a business or entity hedging against related commodity exposure. For example, an oil company trying to protect against a sudden price drop in the price of crude would sell oil contracts against its output. Then, if crude prices fall, the producer has locked in the right to deliver oil barrels at a higher price. (And if prices rise, it simply won’t make as much profit – since it spent money hedging its position.)
A mutual fund might use futures and options contracts to offset long stock and/or bond positions and mitigate risk… this would also fall into the commercial category.
But non-commercial positions, by definition, aren’t hedged. These are speculators making one-way bets up or down on the underlying commodity. For instance, hedge funds that use futures contracts to try and profit. They’ll build positions both long and short based on where they think the stock is headed.
These are the positions we want to watch – because it’s this figure that shows what investing professionals are doing. (Retail investors tend to stay away from this volatile, highly leveraged market.)
However, just watching the back and forth of options positions isn’t going to tell us a ton. They’ll move incrementally every week. It’s the extremes that are noteworthy.
Because when everyone is crowded into the same side of a trade, it means the idea is running out of steam. And that lack of incremental buyers or sellers implies the underlying asset is about to head in the opposite direction.
Based on the most recent CFTC figures, hedge funds are very bearish on the S&P 500…
The above chart shows the current speculator positioning in S&P 500 futures contracts. According to the data, non-commercial traders are net short 376,023 contracts. Based on data going back to 1996, that’s the biggest short position on record. In fact, it’s larger than what we saw during the depths of the financial crisis and COVID pandemic.
All told, we looked at the six prior episodes of extreme short positioning. And they’ve been fantastic indicators. Take a look…
In the table above, the left hand-column is the position report’s release date. Next to it are detailed the percentage changes up or down over the following three-, six-, 12-, and 24-month periods. Then, at the bottom, we tabulated the average return and the success rate, which reflects how often a positive result occurred.
In the six instances of extreme positioning, the average one-year return for the S&P 500 was 15%, while the two-year increase was 24% (12% annualized). A positive return resulted five out of six times, or 83%.
Now for perspective… the S&P 500 historically has returned about 9.5% per year So, that’s our benchmark for how we want to judge the future return potential. And in this case, the historical data tells us that the setup with extreme short positioning tends to produce above average long-term gains for equity investors.
Here’s a visual of the one-year results versus the average gain when this setup has happened…
And here’s the same for the historical two-year gains…
Stocks Are Headed Higher
As the saying goes, history doesn’t repeat, but it often rhymes…
Speculator short positioning in stocks has reached an extreme. Non-commercial investors all piled into the same negative bets. Before long, those same investors will rush for the exit, creating a scramble to buy back stock.
And based on the way the scenario has played out in the past, the S&P 500 is headed even higher.
If you’re interested in investing in this scenario, we’d recommend looking at the SPDR S&P 500 ETF (SPY).
The fund tracks the performance of the S&P 500 Index. It invests in all the member companies, weighting them by market capitalization. The current dividend yield is 1.6% and pays out on a quarterly basis.
The fund typically trades around 87 million shares per day. So, it’s easy to get into and out of. But remember, because it’s invested in a basket of stocks, investors may not participate in the huge rallies experienced by individual companies’ shares during a bull market rally. But diversification can spare them downside pain during a bear market selloff.
Porter & Co.