Market Update: Dangerous Work for Bulls & Bears

Last week's market activity reminds me of a family whitewater rafting trip we did a few years before the pandemic.

Maine's Penobscot River is off the beaten path. To get to it, you have to drive up I-95, nearly to the Canadian border. Then you make a left turn at a charming little lumber town called Millinocket and hook up with a "river outfitter" who has the rafts, helmets, paddles and a seasoned guide to take you out on rapids.

Anyway, it was great adventure. When we rafted it, the Penobscot was high enough to be Class 3 and Class 4 rapids (with Class 5 being tops). Quite a thrill. But it was a thrill that momentarily turned into terror.

Our inflatable raft was probably 15 feet long, with 8 or 10 of us in it. In the photo, you can see me (the glasses-wearing nerd with helmet on the upper left) and my wife sitting on opposite sides in the back.

Somewhere on that river, we hit a chaotic stretch of water called an "eddy wall" - studded with boulders and foaming, bowl-shaped whirlpools.

For an instant, our raft skated over the top of one of these whirlpools. With no water underneath, the craft literally bent in the middle like a wet noodle.

In the next instant, the raft snapped back into its normal shape. And in the process - it catapulted my wife (in a perfect somersault) right out of the boat!

The story has a happy ending.

She's a strong swimmer and found her footing on a shallow rock in the maelstrom. With us passengers all paddling, the guide was able to maneuver the raft upstream just long enough for us to pull her back onboard before continuing our adventure.

Last week's stock market felt just like that...

For most of the past week and a half, the market was slowly losing altitude - in keeping with my previously-bearish expectations.

Then our market "raft" snapped back into shape, catapulting all the major indexes to their highest levels since late March.

Here's my "short take" on last week...

Yes, it could be a classic, very brief "head fake" going into this coming week's Federal Reserve meeting on interest rates (we'll hear the announcement on their decision Wednesday afternoon). And after next week's announcement, maybe the bear market decline resumes in earnest.

But I doubt it.

Instead, I think there are good reasons to believe the rally could work its way higher - short-term bullish - perhaps for as long as the next 2 to 4 months. I'll explain more below. So it's not a bad idea to try out some additional long positions in beaten-down sectors, in my opinion.

Beyond that, well... let's just say it's an open question.

I harbor many doubts. I'd become more enthusiastic if the riskiest sectors of the market, like small- and micro-cap stocks, improve dramatically and catch up with the performance of the S&P 500 and Nasdaq indexes.

But I think the chart below - showing the number of traders who are either "net long" or "net short" via S&P 500 futures contracts - explains last week's surge, and why it the rally may continue in fits and starts for the next few months.

Note the red circles I've added on either side of the chart? Basically, they tell us that only once before in the past 12 years have more traders been betting against the market, expecting it to go down further.

And the chart above is just for small traders like you and I. Major institutions and hedge funds also have record-setting "short" bets against the markets as well.

What's the takeaway?

When so many people bet heavily bearish on the market, the opposite often tends to occur instead (we just don't know exactly when that reaction is going to tt.

The second takeaway is that these kind of imbalances usually don't clear themselves up after just a couple of days of bullish activity (like late last week).

Bearish-leaning investors are as stubborn as bullish ones. So we can imagine a scenario where it might take weeks or perhaps 2 to 4 months before "bears" are dealt enough pain to give up.

With that in mind, keep your eye on the red diagonal line on the chart below:

If I'm right, then that red line could serve as a sort-of boundary line.

I've seen this kind of thing go on for many weeks, where the market works its way higher-to-sideways, and every so often touches the red line - which smart traders use to pile on to their bullish positions -  and the market surges higher still.

Federal Reserve Hitting "Pause" Button?

Lastly, I know there's a lot of speculation that the Federal Reserve will "pause" on interest rates after next week's meeting.

I have no idea if it will happen or not. I'm not sure it even matters.

It wouldn't be the first time that Wall Street traders - parsing the words of Fed chairman Jay Powell in his post-meeting press conference - decide that they've heard what they want to hear, and bid the market sharply higher anyway.

In other words, it may not matter what the Fed says or does next week. The record amount of short-selling activity, and bearish mindset of many traders (myself included until the end of last week) serves as gasoline for a rally. The Fed meeting becomes an excuse to carry the rally further and higher.

Sell in May...But Keep Buying Anyway?

Lastly, keep in mind that we're hitting the summer months soon.

Trading activity shrinks. Trading volume drops off.

Under those conditions, it becomes very easy for Wall Street pro traders to "carry" the stock market.

In other words, they could make the stock market rally farther and for longer than we might think possible - and in the process crush bearish-leaning traders.

Bearish Outcomes: What about Inflation, Higher Rates & a Slowing Economy?

So even though I'm saying "expect a rally" over the next few months, there are important reasons not to throw caution to the wind.

We need to keep in mind that bear markets are treacherous.

Big rallies often occur in the midst of bear markets simply because there are too many people who become too bearish, too quickly.

When they all bet heavily on the same downward outcome, it sets up an extended reaction in the opposite direction...until enough people are convinced to abandon their bearish positions.

And only then does the next phase of a bear market begin.

That's why this is dangerous territory for bears - and bulls alike - right now.

Best of goodBUYs,

Jeff Yastine