Signs of Speculation

The market continued its unstoppable bull run and set new highs in the last holiday-shortened week. Part of the bullishness is justified and linked to a much improved earnings outlook. However, as fresh new records are achieved, we must also ponder the possibility that at least part of the current advance is due to speculation. Sometimes rampant speculation, as we’ll see below.

We’ll start off with our own sentiment indicator, which currently indicates Greed, but not quite euphoria. This computation is “self-calibrating” so that extremes are recorded only 5-6 times over a 2 year historical period. Even though the current environment is certainly “optimistic”, there have been instances of more extreme greed in the past — that is why our indicator is not hitting its upper boundary at the moment. As we’ve discussed previously, markets cannot keep setting records without a good dose of optimism, so by itself this is not an issue.

However, optimism becomes an issue when it gets extreme. Take the chart below for example, posted on The Daily Shot. It shows how investors are throwing caution to the wind by taking on additional risk through the use of leveraged products. In this case, the 3X leveraged S&P 500 Bull ETF by Direxion, which has seen rampant inflows.

As risk-taking is rewarded by higher prices, investors tend to forget the destruction of capital that occurs on the way down.

And the 3X Direxion product is not the only leveraged ETF that investors are piling into. There has been a surge of inflows in ALL levered ETFs. Such a massive increase in volume can turn into a self-reinforcing feedback loop due to the way leveraged products are designed. Usually, these ETFs contain options spreads that force market makers to buy the underlying instrument as it rises in value (think GameStop mania).

When prices rise simply because prices rise — that’s when optimism crosses the threshold into “euphoria”.

And the 3X S&P 500 ETF is a tame product compared to levered single stock ETFs. These have become more popular recently, like the 2x Long ETF (MSTU) for Microstrategy (MSTR), the 5th most traded ETF on November 20th.
Consider that MSTU is a 2X leveraged product on a company which itself is a levered version of a speculative asset (bitcoin). And that was the 5’th most traded ETF by volume…

After that high, MSTR had a 1-standard deviation Drawdown of about -25%, wiping out a large chunk of speculators. Classic move, which really comes as no surprise. The outcome of speculation is always the same (not good for bag-holders).

However, the most challenging part for us is to correctly appreciate when the tide of extreme speculation starts to reverse. There will come a time when prices fall simply because prices keep falling, and leverage unwinds.

However, that time is not now. We are seeing the warning signs of speculation starting to build up, but there is enough bullish sentiment left to keep pushing equity markets higher in the near term.

Technically, the setup remains very bullish as well. Support at the 50-DMA is solid near $582 and upside climbs to $622 (R1). Long, medium and short term trends are positive. There is literally no reason to be bearish on this market at the moment.

Our Trading Strategy

We are working on our fundamental bottom-up market forecast for the next year. That research will lay the groundwork for our investing in the next couple of months. In the immediate term, we expect some weakness in the second and third weeks of December as mutual funds make annual distributions.

Once this period is complete, the Santa Clause rally can commence, especially as the Fed is expected to cut rates in mid-December. We will be buying dips for our client portfolios which are not yet fully allocated to the market.

Risk management is still “a thing”. While there is no reason to be bearish, we will sell down any position which violates a stop-loss.

Note: our usual Portfolio Rebalancing Article will be postponed for next week, as our research is fully focused on the new S&P 500 Bottom - Up Valuation and Market Outlook for FY 2025.

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