So where is this rally headed now? And how long will it run?

09/23/2010 12:08 pm EST


Jim Jubak

Founder and Editor,

Why have stocks rallied so strongly in September? I don’t think it has anything to do with currently observable improvement in the economy. I think what we have seen so far is investors—mostly hedge funds—who had bet that the economy was going to sour reversing that bet to get at least neutral on the economy’s prospects over the next six months.

We all tend to look first for fundamental reasons for market moves—because, well, because it’s logical that if stocks are going up it must be because the economy is getting better.

That ignores the stock market’s propensity to look ahead. If fundamentals do count—and they always do in the long run but we’re talking about a three-week rally here—what counts aren’t current fundamentals but the fundamentals in the economy six months from now.

Of course, investors never actually know what the economy will look like in six months. Sometimes projecting that far out isn’t too difficult: the economy is in a strong trend one way or the other that’s pretty likely to run for six months or longer. Sometimes—like now—projecting that far out is really, really hard. Slow recovery? Better than slow recovery? No recovery? All are possible in the next six months.

So buying now is a bet—sometimes more risky and sometimes less—that you know what the economy is going to look like six months from now. Some investors avoid this whole issue by buying good stocks no matter what the economic forecast and holding as long as they remain good stocks no matter what the economic forecast.  But a significant number of traders and investors try to improve their returns by making directional bets on the economy and the financial markets. An additional group of traders and investors isn’t trying to improve return by making these directional bets. Their total strategies are based on figuring out these macro directional moves.  (Sometimes both groups hedge those bets using a variety of strategies and instruments, which in turn change cash flows in the market in very complex ways.)

If we can judge from cash flows now, in July and August a large percentage of both these groups was placing bets that the direction of the economy was from worse to worser. Strategies of varying complexities were all equivalent to going short stocks.

Now it looks like these cash flows reversed in late August and in September and traders and investors who were betting on things getting worse over the next six months moved to neutral or to a bet on things getting better over the next six months.

Traders and analysts who watch where the cash is going reported an increase in short-covering by hedge funds. That means hedge funds, who had sold borrowed stock in a bet that by the time they needed to return the borrowed shares, they would be able to buy them for a cheaper price in the market, had started to buy those shares and return them because they wanted to protect their profits and didn’t think stocks were about to go much lower.

These same traders and analysts reported that they’re seeing strong cash flows into ETFs (Exchange Traded Funds), which are a favorite instrument for hedge funds looking to short-entire countries or sectors. ETF buying now would be a reflection of these hedge funds moving from a negative position in equities (more short than long) back to something like their normal weight.

Why is all this important to you?

Because it tells us individual investors something about how long this rally might last. If what we have been seeing is buying by hedge funds and other traders and investors to get back to neutral or longer in equities, then you and I need to worry about the rally coming to an end when this rebalancing is finished. These groups of traders and investors aren’t going to chase stocks higher. They’re going to move to the equity position that their strategy recommends and stick there—unless they see evidence to convince them that the economy will be stronger than expected in 6 months.

If this kind of cash flow and strategic rebalancing is the major driver of this rally, then what we’d expect to see is volume starting to dry up as the rally goes on. And there’s some evidence that this is indeed what is happening now. What you’d like to see is more money coming into the market as a rally goes on as investors who were on the sidelines get sucked in by their desire not to miss the rally. Instead, if you track the volume of the S&P 500 ETF , SPY, this rally has yet to produce above-average volume for any day in September, according to Arthur Hill on

This lack of volume is, in my opinion, the most worrying thing about the rally at this point.

Individual investors have a history of getting sucked into rallies at exactly the point when traders and big money investor start to leave the market. I don’t think they’re leaving yet—but I’d certainly be watching daily volume here like a hawk. (Tracking volume on the SPDR S&P 500 ETF (SPY) is a pretty good way to keep an eye on volume.) Up days for prices with declining volumes would be a very clear danger sign.

Be careful out there.

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