Short sellers are responsible for quelling market optimism. These bears have been largely absent lately. When they finally return, it could come as a shock to unwary investors.
It’s shaping up to be a great year for the stock market so far.
S&P 500
So far, it has returned 15 percent, beating all but the most optimistic forecasts. Faced with huge gains, short sellers — investors who bet against the market — are giving up.
Two of the largest exchange-traded funds
SPDR S&P 500 ETF Trust
And a focus on technology
Invesco QQQ Trust,
A recent report from JP Morgan said the Series 1, a popular market indicator, is at its lowest in six years.
.
According to JPMorgan, short interest was as high as 15% of the fund’s total value as of 2023. Today, both figures are below 9%.
As the bull market continues, some bears may simply be giving up, in part due to more onerous regulation and the recent meme-stock boom that has hurt some short sellers, according to JPMorgan.
Either way, the withdrawal of short sellers has likely helped rally stock prices and curtailed recent market volatility. Bears have been steadily becoming buyers in the stock market as they liquidate their holdings. This could be viewed as a slow market-wide short squeeze.
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JPMorgan noted that this move could create potential problems for investors: If market sentiment starts to worsen, short sellers could rush to renew their bearish bets, hurting an already fragile market.
In addition to bear hibernation, there are other reasons to worry that the market rally may not be as robust as it seems.
While short sellers are retreating, there are signs that retail investors are getting ready to step in. A recent report from Apollo Global Management found that the share of retail investors who expect the market to rise a year from now has jumped in the past nine months, from about 35% for most of 2023 to about 40% now.
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“Once the Fed started talking about cutting interest rates, households became bullish on stocks,” the firm said.
Bullishness from retail investors tends to be a negative sign for the market, as they tend to only get excited about stocks at the end of a bull market when prices outperform fundamentals.
There’s also the nature of this bull market itself, with most of the market’s gains being driven by a relatively small number of tech stocks benefiting from investor excitement about artificial intelligence, a situation that has drawn frequent comparisons to the internet bubble of the late 1990s.
So how can investors protect themselves if the stock market rally in 2024 becomes increasingly volatile?
The obvious answer is to stick with bonds. Bonds have been a big disappointment. Investors were hoping for a bond rally this year due to interest rate cuts, but that never happened. Instead,
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iShares Core U.S. Aggregate Bond ETF
It will essentially plateau in 2024 and has been trending downward for the past three years.
Still, bonds can help reduce portfolio volatility.
10-Year Government Bond Yield
Bond yields have fallen from a high of 4.71% in May to around 4.26% today as investors become more confident of rate cuts later this year. (When bond yields fall, bond prices rise.)
Investors looking for downside risk protection within their stock portfolio can also consider covered call funds.
JP Morgan Equity Premium Income ETF,
The largest actively managed ETF. This fund issues out-of-the-money call options on stock market indexes, meaning investors miss out on some of the upside, but earn a call premium that translates into additional yield and a big cushion when stock prices fall.
Email Ian Salisbury at ian.salisbury@barrons.com
