Short sellers are piling on small caps amid the recent selloff
The latest CPI reading ultimately threw a wrench into any hope that the Fed would back off from its initially hawkish interest rate stance. It's brutal out there; gas prices are above $5, the Ukraine-Russian war slogs on, and even the coronavirus continues to linger. Everywhere you look, especially as it pertains to stock market news, there are negative headlines. As contrarians, we're here to remind investors that there's opportunity in rampant pessimism.
In last Monday's Playbook of the Week, Schaeffer's Senior Market Strategist Bryan Sapp showed charts that signify just how dreary sentiment is. Below is an excerpt:
"I got this chart below from SentimenTrader, and I thought this was really interesting. Everyone is calling this a bear market rally. The top chart is the S&P 500 going back to 2012, and then this bottom histogram is a volume chart. It's the number of news articles that have been published that have 'bear market rally' as the topic. As you can see, we're way above bear market rally calls from the Covid selloff, when we got the sharp move off the lows.
If you look now versus the pandemic, people are much more bearish, or at least writers are writing much more bearishly than what they were couple of years ago. This, in turn will have an effect on investor sentiment. If everyone's reading the Wall Street Journal, the Financial Times, MarketWatch, whatever it may be, subconsciously to some extent that will bleed into people's psyche. I don't necessarily disagree; all I'm saying is that sentiment in the very short term has gotten very bearish. And despite the big rally we had two weeks ago, sentiment really hasn't flipped much since.
I also thought this was very interesting; Senior Quantitative Analyst Rocky White does an aggregate short interest reading for all stocks, and he likes to look at the indices to see where big money is shorting and where big money is buying. If you look at the below S&P 500 Index (SPX) chart, the red line is total short interest. This has been trending lower as the market has been trending higher. Short interest really, really rose after the housing bubble and this was a multi-year thing. And it's just slowly been sort of working lower as the market has risen since.
Compare that to the chart below. This is the Russell 2000 Index (RUT) short interest. Total short emphasis on the Russell 2000 stocks right now is at an all-time high. We're at over eight billion shares sold short, and this has been trending higher. I thought that discrepancy was very noteworthy. Hypothetically, let's just say CPI comes in way below expectations on Friday, that would most likely put a huge bid into the market. And the stocks that would most likely benefit the most from that are these highly shorted Russell 2000 stocks. So just something to keep in mind; if sentiment flips, on the whole, if everyone gets really constructive, and everyone gets really bullish, I think there's going to be a really good opportunity on the long side to buy some of these highly shorted, beaten down small cap names."
Narrator: CPI did not come in way below expectations on Friday. But that doesn't necessarily throw cold water on Sapp's comments above. The sentiment readings he called out could conceivably get even more bearish. It's already happening; the University of Michigan consumer sentiment survey on Friday hit an all-time low. The Cboe Volatility Index (VIX) on Friday got as close to 30 as its been in three weeks. Also consider Investors Intelligence (II) data for June 3, where bulls are below their long term average since 2005, while bears are much higher than the long-term average. This was a week ago, when the Dow and SPX were fresh off monthly wins. Imagine how bold bears will be now that there's dismal inflation to back up their pessimism.
Just because everyone is saying 'bear market' in the news doesn't necessarily mean they're incorrect. In Sapp's words, "the trend is still down, this is not a time to say, okay, everyone's negative, we're rallying the bottoms." But just how Bernie Schaeffer beat Jim Cramer to the Hershey's (HSY) breakout a few months ago, an investor that can understand the impact of how sentiment can build and subsequently unwind can find themselves well-positioned to stay ahead of the trend.
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Subscribers to Chart of the Week received this commentary on Sunday, June 12.