A Squeeze Play in the Making

Tue, May 31, 2016 - 8:35am

Originally posted at Briefing.com.

The suicide squeeze play in baseball is a sight to behold. It is filled with tension because it involves a binary outcome. The runner trying to make it home from third base will either be safe or out. There is no middle ground.

In the stock market, investors often choose a middle ground. There isn't a lot of tension there on the surface of things because choosing the middle ground—a neutral position if you will—limits your exposure to the stock market's swings.

The remarkable thing about having a neutral market view, though, is that it is almost always wrong.

A Little History Goes a Long Way

Going back to 1929, the S&P 500, excluding dividends, has been unchanged for the year (which we'll define as a move up, or down, of less than 1.0%) only five times—1947, 1948, 1970, 2011, and 2015. In other words, the success rate of having a neutral stance on the market in the 86 years between 1929 and 2015 is a lowly 5.8%.

There are different variations, though, of what it means to have a neutral view of the stock market.

  • It could mean one simply has a market weight position in the ten economic sectors (i.e., they are neither overweight those sectors nor underweight those sectors, yet they are "in the market" and will perform in-line with the market)
  • Others might define a neutral stance as being hedged/diversified in such a way that one's capital is preserved irrespective of the variability of sector performances
  • And others still might define a neutral stance as sitting in cash on the sidelines

Investors are regularly told to take emotion out of their decision making. It is good advice, yet it is easier said than done for most individual investors.

Investor sentiment has a significant bearing on decision making and that sentiment changes regularly throughout the course of a year.

We know this thanks to the individual investor survey conducted each week by the American Association of Individual Investors. The data from the survey represents what direction individual investors feel the stock market will take in the next six months—and the latest survey was a real eye opener.

Before getting to the details of that survey, keep in mind that sentiment readings are regarded as contrarian indicators. Accordingly, when bullish sentiment is low, it is highlighted as a potential positive for the market, especially when it is matched against high levels of bearish sentiment.

A Perfect Setup

What the latest survey revealed is that only 17.8% of respondents to the survey have a bullish view of the market over the next six months. That is the lowest level of bullish sentiment since the week of January 14, 2016, and it it is even lower than the 18.9% reading seen the week of March 5, 2009 (i.e. at the bottom following the financial crisis). Incidentally, bearish sentiment hit 70.3% that week.

The long-term average for bullish sentiment is 38.5%, so the latest reading is definitely a low reading.

The latest reading for bearish sentiment, meanwhile, is 29.4%. That is below the long-term average of 30.3%. For some added perspective, it is also well below the 48.7% reading seen the week of February 11, 2016, when bullish sentiment stood at 19.2%.

Over the next ten weeks, the S&P 500 surged 15%.

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So, there is low bullish sentiment right now, yet there isn't high bearish sentiment.

What is high at the moment is neutral sentiment. It stands at 52.9%, which is the highest reading since the week of April 12, 1990, and well above the long-term average of 31.2%. In fact, neutral sentiment hasn't been above the 52% mark since 1990.

That elevated level suggests to us that conditions are ripe for a "flat squeeze," only it is indeterminate if a flat squeeze will be a bearish or a bullish development.

It Can Cut Both Ways

Many pundits will be quick to point to the remarkably low level of bullish sentiment as an encouraging contrarian indicator that suggests the market is ripe for a "short squeeze." It could be, yet this pundit isn't totally sold on it because it isn't matched with a high level of bearish sentiment.

The point I'm sold on, based on the extremely high reading for neutral sentiment, is that there heightens a potential for a "flat squeeze" that could cut either way for the market.

Looking at the data set from the American Association of Individual Investors, which dates back to 1987, the most analogous period in our judgment to the sentiment readings seen today was the week of September 9, 1988, when bullish sentiment was 17%, neutral sentiment was 52%, and bearish sentiment was 31%. For what it's worth, the S&P 500 was up 4.2% four weeks later.

As an aside, neutral sentiment topped 51% the week of December 31, 2015. That was the first time it has been above 50% since the week of February 7, 2003. The survey for the last week of December also showed bullish sentiment at 25.07% and bearish sentiment at 23.62%. Four weeks later the S&P 500 was down 8.7%.

A lot of individual investors aren't expecting any big move for the market over the next six months, so if the market starts to get away from them, that could force a squeeze play that exacerbates the directional bias of the move.

We saw that in a certain respect in the last week as the market rallied big-time Tuesday and Wednesday in a surprise move of sorts.

It was surprising in the sense that Tuesday's big gain occurred without any convincing headline catalyst. The rally continued on Wednesday with some supportive headlines (a bailout deal for Greece and polls showing UK voters are likely to vote in favor of remaining in the EU). The biggest catalyst on Wednesday, though, was the market holding its bullish form following a report that showed new home sales in April hit their highest level since January 2008.

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The rally after that strong report conveyed a sense of appreciation by the market that the Federal Reserve is going to be raising the fed funds rate soon for the right reasons as opposed to simply raising it to have some additional rate-cut insurance in its back pocket for the next downturn.

It is possible, however, that the rally on Wednesday was over-analyzed.

It may not have been driven so much by the enthusiasm for an impending rate hike as it was simply by the tape itself, which triggered a short/flat squeeze in a week that was expected to be relatively uneventful leading up to the Memorial Day weekend. Trading volume wasn't exactly heavy either.

What It All Means

The overarching point is that there are a good number of individual investors sitting on the fence when it comes to the market outlook.

They are cognizant that the stock market made a huge contrarian move starting in mid-February, and that is why we would argue this week's gains were exacerbated by a flat squeeze that led to increased buying interest in the fear that they might miss out on another big rally in the near term.

If the market starts acting poorly again, though—for whatever reason—the flat squeeze could just as easily feed into increased selling interest.

There is still a lot of room for a shift in individual investor sentiment. That means there is a real squeeze play in the making because so many individual investors are taking the middle ground at the moment.

How they ultimately get squeezed into the action will be a sight to behold and the likely driver of the S&P 500 breaking out to a new all-time high or simply breaking down again.

As we roll into summer, we sense the tension is building on the stock market's base path.

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Chief Market Analyst
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