Why have stocks rallied so strongly in September? I don’t think it has anything to do with currently observable improvement in the economy. I think what we have seen so far is investors—mostly hedge funds—who had bet that the economy was going to sour reversing that bet to get at least neutral on the economy’s prospects over the next six months.
We all tend to look first for fundamental reasons for market moves—because, well, because it’s logical that if stocks are going up it must be because the economy is getting better.
That ignores the stock market’s propensity to look ahead. If fundamentals do count—and they always do in the long run but we’re talking about a three-week rally here—what counts aren’t current fundamentals but the fundamentals in the economy six months from now.
Of course, investors never actually know what the economy will look like in six months. Sometimes projecting that far out isn’t too difficult: the economy is in a strong trend one way or the other that’s pretty likely to run for six months or longer. Sometimes—like now—projecting that far out is really, really hard. Slow recovery? Better than slow recovery? No recovery? All are possible in the next six months.
So buying now is a bet—sometimes more risky and sometimes less—that you know what the economy is going to look like six months from now. Some investors avoid this whole issue by buying good stocks no matter what the economic forecast and holding as long as they remain good stocks no matter what the economic forecast.  But a significant number of traders and investors try to improve their returns by making directional bets on the economy and the financial markets. An additional group of traders and investors isn’t trying to improve return by making these directional bets. Their total strategies are based on figuring out these macro directional moves.  (Sometimes both groups hedge those bets using a variety of strategies and instruments, which in turn change cash flows in the market in very complex ways.)
If we can judge from cash flows now, in July and August a large percentage of both these groups was placing bets that the direction of the economy was from worse to worser. Strategies of varying complexities were all equivalent to going short stocks.
Now it looks like these cash flows reversed in late August and in September and traders and investors who were betting on things getting worse over the next six months moved to neutral or to a bet on things getting better over the next six months.
Traders and analysts who watch where the cash is going reported an increase in short-covering by hedge funds. That means hedge funds, who had sold borrowed stock in a bet that by the time they needed to return the borrowed shares, they would be able to buy them for a cheaper price in the market, had started to buy those shares and return them because they wanted to protect their profits and didn’t think stocks were about to go much lower.
These same traders and analysts reported that they’re seeing strong cash flows into ETFs (Exchange Traded Funds), which are a favorite instrument for hedge funds looking to short-entire countries or sectors. ETF buying now would be a reflection of these hedge funds moving from a negative position in equities (more short than long) back to something like their normal weight.
Why is all this important to you?
Because it tells us individual investors something about how long this rally might last. If what we have been seeing is buying by hedge funds and other traders and investors to get back to neutral or longer in equities, then you and I need to worry about the rally coming to an end when this rebalancing is finished. These groups of traders and investors aren’t going to chase stocks higher. They’re going to move to the equity position that their strategy recommends and stick there—unless they see evidence to convince them that the economy will be stronger than expected in 6 months.
If this kind of cash flow and strategic rebalancing is the major driver of this rally, then what we’d expect to see is volume starting to dry up as the rally goes on. And there’s some evidence that this is indeed what is happening now. What you’d like to see is more money coming into the market as a rally goes on as investors who were on the sidelines get sucked in by their desire not to miss the rally. Instead, if you track the volume of the S&P 500 ETF , SPY, this rally has yet to produce above-average volume for any day in September, according to Arthur Hill on Stockcharts.com
This lack of volume is, in my opinion, the most worrying thing about the rally at this point.
Individual investors have a history of getting sucked into rallies at exactly the point when traders and big money investor start to leave the market. I don’t think they’re leaving yet—but I’d certainly be watching daily volume here like a hawk. (Tracking volume on the SPDR S&P 500 ETF (SPY) is a pretty good way to keep an eye on volume.) Up days for prices with declining volumes would be a very clear danger sign.
Be careful out there.
TEVA was recently slammed by a negative comment from one Wall Street research firm saying it may loose patent sooner than thought. Though the stock price has recovered quite bit, but still damages were done. (Cramer had an article slamming that Wall Street firm.)
UTA was slammed by a blogger recently, but the company strongly denied the accusation (or rumor) and has scheduled conference call to address any concerns that investors may have. The company also is looking into legal options. That stock has recovered some level too, but still lots loss.
This just to show how Wall Street firms can MOVE the stock price. Getting caught in that wave is quite inconvenient at least.
I never buy or sell based on Wall Street up/down grade. However, I do see their recommendations move the market a lot. (Two stocks recently got slammed by Wall Street downgrade). Sometimes they can be very inconvenient, at least.
and downgrades!
“more often than not analysts downgrade stocks AFTER they have dropped a lot already and upgrade them when they are peaking. ”
I hold an even more sinister view. I believe analysts often downgrade to shake people out and lower price more prior to their companies taking a position. I have no way of confirming it, but suspect strongly that the recent downgrade of MU by Goldman Sucks was preparatory to Goldman buying in. It certainly went up a lot today. Unfortunately there is no way to know unless they take more than a 5% stake, and even then it will be long after the fact.
People who buy or sell based upon analyst upgrades and downgrades obtain results appropriate for people who buy or sell based upon analyst upgrades!
yx:
I think you are right that Monsanto and Nucor are totally different. Monsanto got way overpriced because of it’s position in genetic seed. It was hyped much like a pharma company with a new drug. I’m pretty sure Jim Cramer screamed about it many times on his show…buy buy buy, lol.
Seems like they overplayed their hand in the marketplace, the hype bubble burst, and they are back to a more reasonable multiple. I think roundup may have also lost it’s patent protection. Just a couple pieces of bad news ripped the heart out of a momentum stock and the price dropped like a hot knife through butta. I guess I don’t think Nucor is in that category although it does trade at a premium to other steel companies because of it’s excellent track record. Time will tell but there is that nice dividend to cushion the blow if it takes a while to make a comeback.
tazman:
Thanks for sharing your thought on NUE. I was watching the stock too, but the downgrade made me fear it may become anther Monsanto (though totally different industry). Both companies have the products that the world needs, but some strategic error plus long-delayed demand depressed the stock. That’s the case for MON and it keeps making new low. I was fear the same for NUE. I thought Goldman may know what we don’t. Maybe you are right. At least judging by today’s news, durable goods order up, spells more demand for steel.
I sold both Deere and Cummins very early, though at very substantial gains. Even though these two further went up, I can live with my decision. Because when an investment keeps making new high, the game is very tricky. That’s what gold is doing.
Anyone has any thought on gold’s new high?
crabby…..selling a winner is the toughest thing isn’t it? My strategy is based on my personal psychology and my stock rating system. When a stock gets near my upper target I start selling in increments. That way I can be happy either way. If it goes up some more I still have some. If it goes down it proves I was right to sell! The other way to look at selling is rotation into stocks with better risk/reward ratios. Discipline is essential unless you like to do a lot of round tripping. It is especially critical to take profits in stocks that do not pay dividends. Then there is less reward for patience.
Deere is a great company in a great market for the long haul. I would love to own some but it is too expensive for me right now. If I owned it I would take a little profit but keep some in the game. With a dividend around 1.7% it beats money markets if you have to endure a pullback. I don’t follow Cummins but I’m glad you have a nice profit!
yx……to the contrary, at least for me, a downgrade by a Wall Street analyst is often a contrary indicator or a signal to look for a good buying point on a stock I like that has been too expensive for my taste. I always do the analysis ahead of time and decide on my price points, so a downgrade is often a gift that gives me my entry price. Of course I look for things that have changed but more often than not analysts downgrade stocks AFTER they have dropped a lot already and upgrade them when they are peaking. This has more to do with how Wall Street works than it does with good stock picking and that is a whole lot more paragraphs than I have here!
Nucor is a terrific company that is very well managed. It yields over 3.5% and is selling for the lowest price since the march09 bottom, down over 20% from fairly recent highs. Industrials like this will do well in a recovery. I will clip the dividend while i wait for it to get back in the high 40s and will buy more of it falls more. It was a pretty easy pick for me, but that doesn’t mean I couldn’t be wrong…I just like the odds…a lot.
Just for laughs, my current theory is that when Goldman downgrades wait two days then buy! I swear they do it just so their favorite clients and their own traders can get a better price!
I am shorting the market (small position). Its looks toppy to me. Risk reward isn’t there. The big money is waiting for the retail investor to buy and drive prices higher. Once its high enough, they are going to slam you down with a lot of selling…don’t let them bait you in.
Thanks for the very interesting and timely article.
Tazman:
Would you explain why Wall Street’s down grade on steel did not deter you from buying NUE?
Tazman got it right for those of us who buy individual stocks. We have to pick the right companies, we have to buy them at reasonable prices, and, toughest of all, we have to decide when to sell them. Two, examples, Deere and Cummins. Both have run up very nicely since they were recommended here in the recent past and I have very nice profits in both. Is it now time to sell? Based on its prospects for the future, Xerox looks like a good buy to me, so I just purchased 400 shares.
yes, but low volume was one of the arguments that the rally from march 09 was over after a couple months and wasn’t going anywhere. in spite of that, the SPX rallied from from around 900 to over 1200 at about the same volumes we’ve been seeing on the latest rise, right?
A very interesting analysis. My takeaway from it that individuals should understand that this kind of thing is going on and basically ignore it. Pick your companies, pick the price you want to own them at and the price at which you think they are overpriced. Pull the trigger accordingly. All this hedge fund action is just background noise except that it does give an individual some fantastic buying opportunities on occasion. Conversely, some very overpriced situations also occur. We can make money either way with a little discipline. I’m bought more Nucor (NUE) today at $37. Thank you to the Wall Street analysts who downgraded it! tazman4846 on twitter.