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Chart Advisor: New Threat

Investopedia

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Thursday, January 28, 2021

1/ Investors spooked after Fed news,because…GameStop?

2/ Why the professionals were worried 

3/ It could be just the Turn of Month effect 

4/ The bottom line

1/ Investors Spooked After Fed News, Because… GameStop?

Stocks sold heavily when the Federal Reserve announced no policy changes at the close of its FOMC meeting. To some it seemed strange that anyone expected otherwise, but only if they were unaware of the connection between the major market indexes and the GameStop (GME) story. Surprisingly, there is one, and it had the bigger players in the market quite spooked. 

Consider the chart below which shows just how spooked they were, and some would argue, still should remain. The Cboe Volatility Index (VIX) spiked violently to 38 yesterday. This level implied the potential for the S&P 500 Index (SPX) to fall well below its lows for the year. While it did not, and it showed a resilient rebound in today’s trading, the VIX remains elevated well above its previous level. VX Futures (VX) are running slightly higher than the VIX which signals traders expect some additional volatility could still be coming.  

2/ Why The Professionals Were Worried 

Chart watchers by now have heard all about GameStop (GME) stock that caught many too-clever-for-themselves-hedge-fund types in a short squeeze. They had hoped to make money by shorting the stock of the company and profiting from what they assumed was an obvious and inevitable demise. But what wasn’t so obvious to them was just how few shares were available to be purchased, and how many of their peers had the same idea.  

The key thing to understand here is that when a short seller wants to close a trade, they must do so by issuing a buy order for the stock they are shorting. If many big players are shorting the stock, and the price starts to rise, they start losing money. If they all panic at the same time, the opposite of a crash can happen. The overwhelming influx of buy orders that results is the same dynamic that caused Volkswagen shares to run to a price level over $1,000 back when the Porsche family engineered a takeover of the company.  

While the current narrative points a finger at Redditors for causing this, the dynamics at play are more likely to be orchestrated by players with more money available to them than the mass of retail traders. However, if the prevalent news pans out to be accurate, it could have implications that still aren’t obvious to most people right now.

As Thomas Hayes, managing member at Great Hill Capital LLC, New York, put it in a Reuters news article earlier today: “If (GME) had kept going higher, that just means more hedge funds would have had margin calls. I think when it backed off a little bit, the market breathed a sigh of relief.” His comment implies that many funds might have had to sell some of their other stocks to make up for the losses they were sustaining on GME. That could have created a wave of selling that could ripple through all market participants’ portfolios with unpleasant ramifications. 

As the chart below shows, the problem was bigger than just GME. A similar short squeeze took place on AMC Entertainment (AMC) and Koss Corp. (KOSS) as well. In the end, Invesco’s Nasdaq 100 Index ETF (QQQ) came roaring back today as investors took opportunities to buy the dip, emboldened by the good news from Apple (AAPL) and Facebook (FB). 

3/ It Could Be Just the Turn of Month Effect  

Chart watchers may appreciate an additional observation of a technical factor that is likely going under the radar right now. The Turn of Month effect identified by researchers in 2014 (and mentioned in this newsletter as part of a report on the Santa Claus rally) may be at work by adding the influence of late-month portfolio balancing into the market indexes.  

Consider the chart below which illustrates how one might argue that late-month selling and early-month buying has visibly occurred over the past six months on SPX. If this were a contributing factor to the recent market behavior, it might imply that things are simply moving along as normal. Perhaps this tempest won’t spread beyond the cup of tea that January of 2021 has been so far. While that might be a comforting thought to some, chart watchers should remember that the VIX is advising investors not to buy into that level of complacency.  

Perhaps that is why some market professionals may have surreptitiously hoped the Fed would step in and offer more monetary policy actions to spur the market higher. Thus, when it was not forthcoming their fears, and selling, intensified. 

4/ The Bottom Line 

Stocks rebounded from yesterday’s selling frenzy, but the VIX did not settle back down to previous levels. The stunning headlines surrounding GameStop and other companies has market professionals wondering where the new threats in the market might come from. The selling could just be nothing more than normal monthly dynamics, but it has left investors worried nonetheless. 

Originally Published on January 28, 2021

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