Bears unwinding positions leaves rallying stocks exposed

The extreme pessimism that’s gripped American stock investors for much of the year is starting to dissipate. That might be reason for caution.

Stock bulls betting the whiff of recession means the worst of the Federal Reserve’s rate-hike medicine has been administered drove the S&P 500 to a second day of gains and the highest level in almost two months.

The rally, and attendant change in sentiment, has forced speculators to unwind bearish positions that once served as a key source of demand when stocks bounced back. With short sellers retreating, stocks might be exposed to a downdraft if the Fed turns more aggressive on future rate increases or corporate profits start to crater.

“Dour sentiment in mid-June was a great contrarian set up for this rally, but that can now be less relied upon with the pivot since, however modest,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group.

Bets against stocks by fast-money traders have largely been removed. Commodity trading advisors that take long and short bets in the futures market rushed to unwind bearish positions they had built over months and now have their overall exposure at neutral for the first time since March, according to JPMorgan Chase & Co. estimates.

Short positioning among CTAs helped check equity and bond selloffs throughout the first half, leading them to some of the best performance. That short covering this month has added fuel to the rally, though JPMorgan strategists including Nikolaos Panigirtzoglou warned that the support is likely fragile.

“While in principle CTAs have room to start building up long positions from here, at the same time we acknowledge that their previous short base has been wiped out,” the strategists wrote in a note. “This implies that if, because of some negative news such as a strong US payroll report that triggers significant repricing of the Fed, momentum turns negative again, there is plenty of room for CTAs to start building up short positions again.”

The observation is echoed by Charlie McElligott, a cross-asset strategist at Nomura Holdings who estimated that momentum traders snapped up $4.8 billion of bonds to cover shorts Wednesday, when markets rallied amid investors are speculating amounts to a dovish Fed policy announcement. Over the past month, CTAs unwound a total of $52 billion in bearish bets, sending the group’s short exposure in bonds to the smallest since last November.

Of course, not all bears have given up. As of July 19, asset managers and leveraged funds were positioned short on equity futures by the most on record, according to Commodity Futures Trading Commission data compiled by Deutsche Bank AG.

But there are signs that sentiment has since improved as stocks embarked on the longest rally of the year, with the S&P 500 jumping 11% from the June low. For the first time since April, bulls identified in Investors Intelligence survey of newsletter writers outnumbered bears.

Still, the rally has yet to convince investors to fully embrace stocks. Equity-focused exchange-traded funds have attracted $10 billion of fresh money over past six weeks, or $1.7 billion a week, data compiled by Bloomberg show. That’s weaker than the weekly pace of $9 billion earlier this year.

“If you think corporate earnings will either remain strong or rebound quickly from any recession, then stocks are modestly attractive here,” said Nicholas Colas, co-founder of DataTrek Research. “Equities are an optimist’s game, and this bullish narrative may have some legs here. We are more in the ‘realist’ camp at the moment and remain somewhat cautious.”