Just a mirage? Traders worry November's strong start is just massive short covering

Published Wed, Nov 8 20239:30 AM EST

There's growing concern among some Wall Street participants that November's hot start has more to do with hedge funds racing to cover their bearish bets than an actual change in the stock market's prospects. "We believe that last week's drop in U.S. treasury yields and sharp rebound in equity markets were driven by an epic short covering rally across asset classes," Chris Senyek, chief investment strategist at Wolfe Research, wrote in a Monday note. "While there could be some additional follow through, in our view, last week's sharp moves continue to look like shorter-term trades, not new longer term trends," Senyek added. The S & P 500 surged by 5.85% last week, its best weekly performance going back to November 2022. The Nasdaq Composite gained 6.61%, its best also since November 2022. Both benchmarks are higher eight days in a row, their best winning streaks in nearly two years. Those moves come as Treasury yields pull back from their multi year highs. The 10-year Treasury yield on Tuesday was below 4.6%, after having topped 5% last month. .SPX 3M mountain S & P 500 But a number of market participants are concerned the rally has more to do with short covering. Selling short is when a sophisticated trader borrows stock from a broker and sells it, in order to buy it back at a lower price and return the shares later, profiting from the difference. Short covering is when the stock, or in this case securities linked to indexes, advance rather than fall, causing investors to rush and buy back the stock before their losses balloon. If done in force, their buying can cause a so-called short squeeze. Shorted stocks surged The Goldman Sachs Most Short Rolling Index, a basket of stocks with the highest short positions, registered a 3.6% advance on Friday. But then just as quickly it fell by 4.4% by Monday afternoon, as pointed out by BTIG's Jonathan Krinsky. Over the last four years, the pattern — a one-day gain of at least 3.6% followed by next-day fall of 3.6% or more — has only happened eight times, according to BTIG. Of those instances, the S & P 500 was down five days after the move, by more than 1% on both an average and median basis. "While this is by no means a guarantee of weakness ahead, we think it speaks to the fact that the last couple of days was largely a function of shorts being covered, and when there is nothing to support that move it gives back a significant portion of that the following day," Krinsky wrote. "This can often act as a fulcrum for the broad market as well," Krinsky added. Commodity trading advisors also accelerated short covering, notably turning short in the front end, according to a Bank of America note on Monday. Elsewhere, Citi's Chris Montagu said S & P 500 futures positioning remains "moderately bearish" following the short-covering rally. "S & P and Nasdaq short positioning declined, as investors unwound profitable shorts," Montagu wrote on Monday. "However, the bearish extension for S & P remains, with short positioning moderate." BTIG's Krinsky anticipates further challenges for the broader index, especially if the Federal Reserve is unlikely to cut rates anytime soon, part of the hope driving the rally. Meanwhile, Wolfe Research's Senyek expects the 10-year Treasury yield will climb back above 5%, and that stocks will fall again by year end.