Squeezing Out Sparks
June 24, 2018
Now if I think, I might break even,
I might go home and quietly,
I'll marry a rich girl, but otherwise
I'm going to raise hell and rightly
-- Graham Parker
A decent bit of ground to cover here, but first an update from last week’s installment. On Wednesday, the U.S. Supremes issued a reversal that now allows states to tax on-line sales for transactions outside their borders. However, the good news is that the internet has not yet begun to recover from the crippling blow of the repeal of Net Neutrality, so it shouldn’t matter much.
With that out of the way, I’m able to inform you that our title is identical of that of a seminal 1979 album by the deeply under-appreciated Graham Parker and the Rumor. This record has a special place in my memory, because it shook me and my crew from the lethargy that had set in from too much focus on psychedelia. It was aggressive, punchy and not overly cerebral. Most importantly, you could dance to it. So, my friends and I got off the couch, put aside whatever materials were sitting on the coffee table, and set forth to shake things up with the ladies (albeit with mixed results).
But in the interest of full disclosure (and its attendant easy discoverability), I must inform you that “Back to School Days” – the actual song from which our lyrics are purloined -- was not on “Sparks”; in fact, it predated “Sparks” by a couple of years. Chalk it up, yet again, to poetic license.
One way or another, my observation is that over the past several sessions, and in the equity markets at any rate, there has indeed been a whole lot of squeezing going on, and that if one looked closely, there were some sparks flying as a result.
Of the former assertion, there is little to debate:
But while the accompanying chart, courtesy of ZeroHedge, shows an unmistakable melt-up, a couple of caveats are in order. First, I’m not sure how the “Most Shorted” Stocks index is compiled, what names it contains and at what weights are. Here, I’m willing to take ZH’s word for it. In addition, however, what is labeled as a “Record Squeeze” derives from the Relative Strength Index (RSI) measure, which I’ve never understood, can’t define, and tend to ignore.
But why quibble with technicalities? Those looking for corroboration in less obtuse metrics may wish to consider the recent relative performance of the SPX and the Russell 2000 benchmark index of small cap stocks:
SPX vs. RTY: A Reversal of Relative Fortune
Now, one can clearly observe that, with few exceptions, over the past rolling year, the Gallant 500 has routinely outperformed its lower pay grade comrade, Ensign Russell. But something changed dramatically in the first half of Q2. The good Ensign started to leave the better fortified 500 in the dust. And, as matters now stand, while the latter has turned out a rather pedestrian year-to-date performance of ~3.07%, the former is knocking on the door of a double-digit return.
Please understand: it’s not my view that Russell stocks are more apt to accumulate short interest than those listed in in the S&P 500, but that squeezes hit small caps harder than large caps.
Mostly this is due to liquidity considerations. For small caps, the volume is lower, the borrow more difficult to source, and, in general, the covering of a short more problematic. So when small caps shoot the lights out against the big dogs – particularly on what can otherwise be described as a flattish tape, one can be pretty certain that the squeeze is ascendant, and one should arrange one’s investment affairs accordingly.
Of course, a short squeeze, as is the case with any other technical (and for that matter, most fundamental) conditions, is a phenomenon that must run its course. But herein lies a further problem: I’m not sure that this here squeeze is over.
Because, you see, my strong hunch is that the overall market is poised to rally over the next several weeks. I hinted at this conviction last week, and so hinting did me no favors in terms of street-cred, but now, as is my prerogative, I’m doubling down. Everywhere I look, I see indications of a vigorous set of economic conditions, and this evidence notwithstanding, longer term global rates are either frozen or trending downward. Earnings look to be pretty solid, and I suspect that on balance they should surprise to the upside. In the meantime, with only 5 trading days left in this crazy quarter, I suspect – on a tape that is likely to feature diminished liquidity -- that investors will do what they can to defend their positions.
In addition to the forgoing, and at the risk of laying some overly heavy philosophy on y’all, I believe that a trading year sets up as a series of hypothesis-testing cycles. Investors typically emerge from their New Year’s stupor with some sort of a consensus as to what kind of year they are about to face, and, for the first several weeks, stay true to this trend. Contrarians inevitably step in at some point, and then the battle is joined, with either the naysayers prevailing or the consensus being reaffirmed. There are typically between 3 and 5 such sequences across a given year.
Entering 2018, the consensus was evident. It was game on, and January was nothing short of a giddy market month. Then the cold winds of February began to blow, we experienced that VIX debacle, and everyone felt the chill. By the end of that month, the markets had regained a measure of equanimity, and since that time, the SPX has traded in an historically narrow, single digit range. With Q2 coming to a close, it bears mention that the index is up all of 14 handles, or one half of one percent, from where it began.
My sense is that it’s time for risk takers to test a new hypothesis, and the one that seems most likely is a rally in stocks and a selloff in government bonds. Of course, the opposite paradigm may emerge, with hypothesis-testing assuming much darker hues, but I feel that if the market takes a visible fall here, it will socialize bargains that are likely to be too tempting for many capital pools to pass upon.
There are a couple of wild cards here, the most prominent one being the trade war psychodrama unfolding before our very eyes -- at social media warp speed. I take these matters very seriously, and, for what it’s worth, believe that the rhetorical brinksmanship emanating from Washington is, at best, counterproductive. It may prove to be the winning strategy, but any number of events beyond direct human control could cause it to derail, with consequences I care not to contemplate. But a few other points are in order.
First, because we’re referencing politicians here, the overwhelming incentive on all sides is to seek a solution that will allow both (all?) parties to declare rhetorical victory, and I think that’s what’s going on behind the scenes. In the mean-time the tweets and statements of the principals here strike me as being nothing but gamesmanship: government power players spooning out messages for public consumption alone: ones that have little to do with the true state of play. This thing may be going well; it may be going poorly, but I don’t think anyone outside of the circle of trust has the first clue either way.
Meanwhile, the markets are reacting, unwisely in my judgment, to every single tweet.
So, if Trump holds to pattern, and after tiring of sending genius or mindless streams of vitriolic rhetoric towards Chair Xi, he enters Kumbaya mode (and even more so if, as I believe is likely, an accord is actually reached), the markets are likely to melt up, and those who have been squeezed recently may feel the squeeze yet again. Moreover, said squeeze may very well expand to hit the credit markets, where short sellers have won recent innings by widening out spreads a pretty good amount in recent weeks.
In case you had any doubts, this chart does not paint a particularly encouraging picture, particularly given that it fails to take into account the interest rate component of credit costs. If rates, at long last, rise, and spreads continue to widen, then we’re looking at a less rosy financial funding picture for everyone from Olympia to Key West.
But even here, I’d encourage my minions to take heart. There’s always Switzerland (still negative) and Germany to look to for funding sources. And, of course (sorry, I can’t resist), we’ll always have Paris.
One last thing, my loves: if I’m right about the next material move in the equity markets being to the upside, I don’t know how long it lasts.
However, I know that the answer is not “forever”, because that option does not devolve to humanity. Back in the day, we were able, for a few months, to bang our heads a bit by “Squeezing Out Sparks”, and for a while, the girls even paid attention. I did raise a bit of hell, but never married a rich girl; only a lovely one from a good family. As most of you know, I’ve not had a minute’s cause to regret this.
But that was later. Once the sparks were all squeezed out, for me and my buds, it was back to the couch, the 4-footer, and yet another spin of “Electric Ladyland” on the turntable.