Markets coming to their senses or just a ‘Bear Squeeze’?

19 February 2016

Over the past week, the direction of stock markets changed markedly for the better, although it waits to be seen whether this will have been the ultimate turning point of the Q1/2016 market correction. Just as was the case with the precipitous declines in the weeks before, market commentators scrambled to identify fundamental reasons behind the trend reversal, when the ongoing news flow was not actually so different from previous weeks. Most quoted was the expectation of stabilising oil prices after Saudi Arabia and Russia agreed to freeze output to January 2016 levels. Second were the soothing statements by the US, ECB and Japanese central bank chiefs that they would maintain their monetary policy support as long as necessary to see economic growth stay on a sustained path of expansion.

Given none of this was truly new news, the most market relevant central bank communication was most probably the 13 page (16 in the original Mandarin) communication from the head of the Chinese central bank in which he reassured currency markets that a significant devaluation of the Yuan/Renminbi versus other currencies is not part of the Central Bank of China’s policy intentions.

Still, from my point of view, not really changes for the better to justify a stock market rebound of up to 10%. More likely that many read the technical market indicators just like we did at Tatton as distinctly oversold and took the opportunity of a low entry point, when the first bits of good news came through. The initial rebound was then most likely boosted by what markets call a short squeeze or bear squeeze which happens frequently when a fair share of speculative investors are caught out by the rising markets. Investors like hedge funds would have taken on short positions to make gains from falling prices.

When their ‘bet’ goes wrong, because markets rise instead of falling, then the only way to limit further losses is to buy the stocks they have shorted which cancels their short position. Given such investors get forced or ‘squeezed’ into buying stocks because of their short positions the resulting market dynamic is somewhat aptly called a short squeeze – more in a separate article further down.

Towards the end of the week, most the technical buy signals as well as the buying pressure to cover previous shorts petered out and so the upward momentum receded. While a number of market commentators concluded that investors had finally come to realise that the 2016 economic outlook is far better than markets anticipate, we do not believe it will be plain sailing from here. Long term investors will most probably have to endure further bouts of downside volatility until this initial rebound turns into a more sustainable trend.

We believe the basis for such a positive trend reversal exists over the next weeks by virtue of the ongoing global economic growth and continued monetary support from the central banks. However, don’t make the mistake to interpret the strong rebound of the past week as a return of investor confidence. If anything, it has shown that in the current economic and financial market environment, the risks are not only to the down- but equally to the up. The timing of these sharp recoveries is hard to foresee and this is why we have maintained a neutral rather than underweight position in portfolio’s stock market exposures.