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The force that has propelled the stock market rally is about to exhaust itself this week. That force is related to a short-squeeze.
Let’s explore with the help of a chart. Please click here for an annotated chart of Dow Jones Industrial Average ETF DIA, -1.66%, which tracks the Dow Jones Industrial Average DJIA, -1.72%.
Note the following:
• The chart shows that 65% of the rally is related to a short-squeeze. As of last Thursday, the S&P 500 was more than 20% higher than its mid-March low, a stunning development.
• The chart shows that many stocks and ETFs fell into the Arora buy zones when the stock market fell.
• A short-squeeze occurs when short-sellers feel compelled or are forced to buy to cover short positions.
• A short-squeeze occurs in waves. The current rally has consisted of many waves of short-squeezes.
• It is important to focus on the word “related” (as in, “related to a short-squeeze.”)
• A short-squeeze often leads to a cycle of other actions.
• As the stock market rises on a short-squeeze, the momo (momentum) crowd jumps in to buy because of the momentum to the upside. This adds to the buying.
• As the momo crowd’s buying continues, buy signals are given on many technical indicators. Then technically oriented traders jump in to buy the stock market.
• On a continued market rise, FOMO (fear of missing out) takes hold, and many investors jump in to buy without fully understanding what is really happening.
• At about this time, some mom-and-pop investors start jumping in the stock market thinking that it is all clear.
• As the market rises, short-sellers put in new “shorts” and the cycle continues.
• The most important thing about short-squeezes is that they ultimately exhaust themselves. This eliminates the artificial buying that propelled a rally in the stock market.
• Investors have said there was no warning of the coronavirus. That’s untrue. On Jan. 22, The Arora Report’s call, as shown on the chart, was that the coronavirus could cause a drop in the market. After finding that investors continued to buy stocks, I wrote on Jan. 30 that arrogance and greed among momentum investors “may prove to be dangerous for investors.” Other than a potential cure, the course of the stock market rally will depend on the behavior of “naked” investors. Please see “‘Naked’ investors — not coronavirus numbers — will determine how much stocks rally.”
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Key stocks
A short-squeeze has been especially vicious in stocks that carry a heavy weighting in the S&P 500 SPX, -1.44%. Short-squeezes have been most notable in Amazon AMZN, +5.00%, Apple AAPL, +0.22%, Microsoft MSFT, -1.09% and Facebook FB, -1.88%. Short-squeezes have also been especially vicious in semiconductor stocks such as AMD AMD, +3.28%, Intel INTC, +1.85% and Nvidia NVDA, +1.03%. Among speculative stocks, Tesla TSLA, +8.75% is experiencing a major short-squeeze. In addition to the stock market indexes, investors should keep a close eye on the stocks mentioned above.
Exhaustion
According to our algorithms at The Arora Report, the short-squeeze-related force that has propelled this stock market rally will likely end this week. There should be downward pressure on the stock market after the short-squeeze ends, unless there are new triggers to the upside such as medical developments against the coronavirus, pleasant surprises in what companies say about the future in their earnings reports and conference calls, more monetary stimulus from the Fed and more fiscal stimulus from the government.
Should you buy or sell?
Bear markets are characterized by sharp rallies. If a cure is found soon, the rally will continue. In the absence of a cure, the probability is high that the rally will fail. Investors should use an objective framework for buying and selling. Please see “Stock market investors are asking ‘should I buy or sell?’ Here’s how to decide.”
Answers to your questions
Answers to some of your questions are in my previous writings. You can access them here.
Disclosure: Subscribers to The Arora Report may have positions in the securities mentioned in this article or may take positions at any time. Nigam Arora is an investor, engineer and nuclear physicist by background who has founded two Inc. 500 fastest-growing companies. He is the founder of The Arora Report, which publishes four newsletters. Nigam can be reached at Nigam@TheAroraReport.com.
