By Nigam Arora
Many investors not familiar with the mechanics of short squeezes are confused by the strength of the stock market rally that began after the S&P 500 hit a coronavirus low on March 23. Short-squeeze-related actions were the force that unleashed the strong rally.
As the market continues to rally, the odds that the stock market will set a new record within the next two months are rising. I see it as 55% now, up from just 30% on May 13. As impressive as that rapid shift is, I will wait until the odds reach 70% to my call.
What will push the likelihood to 70%? The second leg of the short squeeze has to start. And although stocks are surging on Monday, I am not yet seeing this — bid-ask spreads aren’t widening and trades aren’t being done predominantly at the ask price.
Investors should consider what the trigger for that rally may be. One could be success with a coronavirus vaccine. Moderna /zigman2/quotes/205619834/composite MRNA +6.60% has announced positive interim clinical data from its coronavirus vaccine Phase 1 study; the immediate stock market reaction has been very positive. The data is impressive in that the magnitude of the response to the vaccine is of the same magnitude as the body’s immune response caused by a natural coronavirus infection.
It is conceivable that the Moderna news along with more potential good news regarding vaccines from the likes of Pfizer /zigman2/quotes/202877789/composite PFE +0.81% , Johnson & Johnson /zigman2/quotes/201724570/composite JNJ +0.68% , Novavax /zigman2/quotes/202614340/composite NVAX +10.86% and Inovio Pharmaceuticals /zigman2/quotes/202993817/composite INO +10.21% and good news on antivirals such as from Sorrento Therapeutics /zigman2/quotes/205669265/composite SRNE +4.84% , may cause a second leg of the short squeeze to start.
More broadly, the economy is opening up but there is significant uncertainty about how consumers will respond. The trillions of dollars in fiscal stimulus is helping, but stock investors should also be concerned about massive budget deficits and borrowing. The Federal Reserve is increasing the money supply like there is no tomorrow, but there are consequences to a bloated central-bank balance sheet. There is optimism about antivirals and vaccines but there are no guarantees.
Shouldn’t the stock market be taking into account the damage that has already been done to the economy? The answer is the market always looks forward.
Note the following:
• The monthly chart shows that the stock market touched the upper band of the “mother of support zones” and then bounced to the bottom band of the resistance zone.
• In mid-April we called that the rally springing from short squeezes was about to exhaust itself. That call has proven spot-on as since then the market has mostly treaded water for a month around the low band of the resistance zone shown on the chart until the news of success with Moderna vaccine.
• A short squeeze often leads to a cycle of other actions. As the stock market rises on a short squeeze, the momentum crowd jumps in to buy because of the momentum to the upside. As that buying continues, many technical indicators give off buy signals, leading technically oriented traders to jump in.
• On a continued market rise, FOMO (fear of missing out) takes hold, and many investors jump in to buy without fully understanding what is really happening.
• As the market rises, short sellers put in new “shorts” and the cycle continues.
• Based on our algorithms, a stock-market rally related to the second leg of short-squeeze activity may only pause near the upper band of the resistance zone shown on the chart and then continue to new highs.
• However, investors should also consider scenarios of bad news on vaccines, major hiccups as the economy opens and a potential second wave of the virus. From a technical perspective, the stock market is overbought in the short term and it will not take much for a serious drop in the stock market. That is one other reason I am not completely convinced the stock market will quickly reach a new record.
Answers to your questions
Answers to some of your questions are in my previous writings. Please click here for details.
Disclosure: Arora Report portfolios have positions in Apple, Qualcomm, Cisco, Amazon, Alphabet, Microsoft and Facebook. Nigam Arora is the founder of The Arora Report, which publishes four newsletters. He can be reached at Nigam@TheAroraReport.com.