It is easy to forget where we came from, but we can’t.
In the short run, the S&P 500 is at a major crossroads. Either this correction recovers, and we see a melt-up into the New Year and moderately beyond, or we get a holiday wake-up call. We are leaning toward the former due to strong seasonal tendencies, but the reality is the trajectory of this market is unsustainable. At some point in 2022, or sooner if near-term support fails, the complacent bulls will be reminded of why stockholders are rewarded with a risk premium.
The bull market born in March of 2020 has experienced a few shallow corrections but has mostly been a stunning example of a runaway bull market. The rally has made fools of the doubters and trained the bulls to aggressively buy into the smallest of dips. The result has been an unnaturally steep chart pattern that could prove to be a pull-forward of future gains, or much worse, a market that must revert to the mean to normalize price action. Given lofty levels of the major indices, a mean reversion move would be frighteningly severe. While I generally lean toward optimism, I have seen complacency kill traders and investors. There is no room for lackadaisical risk management in a market that can best be described as overcrowded.
Commitments of Traders Report
In the futures markets, we haven’t seen large speculators this long E-mini S&P 500 futures since October 2018, before a rather large decline that didn’t run its course until Christmas Eve of the same year. We saw similarly bullish positioning in early 2018, prior to a sharp correction. Currently, large speculators are holding a net long position of about 167,700 contracts which leaves plenty of room for volatility if the rally continues to show signs of cracking. Not coincidently, we are also seeing historically large short positions in the 10-year note futures contract; large speculators are net short nearly 275,000 contracts. The long stock and short bond bias in the futures markets appear to be in line with the average investment portfolio which looks to be higher stock allocations (and lower Treasury allocations) that are normally the case. If the stock market continues to make it's way higher, this aggressive allocation will pay off nicely but if the masses have it wrong, as they usually do, we could see a chaotic scramble by investors to sell stocks and buy Treasuries. We doubt this portfolio rebalance will happen in 2021, but there is a high probability of it occurring in early 2022.