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Is the Market Setting Up a Bull Trap?

The rally on Tuesday and follow-up today has been an exciting relief after Monday's dismal performance, but it is still somewhat unclear to me that investors are being entirely rational. Traders seemed to welcome dovish comments from the Fed Chair and other Federal Open Market Committee (FOMC) members, although it is important to note that Jerome Powell never actually said the FOMC would "cut" the short-term target interest rate. Even if he had specifically said, "The Fed will cut rates," it is not a decision he can make by himself without the rest of the FOMC.

I don't want to join the ranks of the most skeptical traders and call this a "bull trap," but there were a few signs that the rally may have been driven by factors other than optimism for the Fed. I think we must consider the potential that the spike was at least in part a short squeeze.

A short squeeze occurs when a stock that has been targeted by short sellers suddenly starts to move higher (usually following unexpected news), which creates losses for those short positions. In this situation, short sellers may decide to exit their position, but they must do that by buying the stock, which then increases the bullish pressure already driving the stock higher.

The cycle of short sellers buying back their positions as losses mount can enter a feedback loop where more buying drives the price higher and motivates even more buying. One of the most dramatic short squeezes occurred in 2008 when Volkswagen AG (VOW.DE) briefly became the most valuable public company by market capitalization when short sellers were surprised by a Porsche takeover bid. You can see that dramatic price spike in the following historical chart.

While not as dramatic, the Tuesday through Wednesday rally had some hallmarks of a short squeeze because stocks that were the most heavily shorted were also the most profitable on average. For example, Fossil Group, Inc. (FOSL) is the most shorted stock in the S&P 500, with nearly 30% of its floating shares held short, and the stock rallied more than 12% on Tuesday.

The 50 most shorted stocks in the S&P 500 were up 2.72% on Tuesday compared to the S&P 500 itself that rose 2.14%. The 10 most shorted stocks in the S&P 500 were up 4.29% on Tuesday, which should help you see the emerging pattern.

To be clear, I remain cautiously optimistic that the market will rally back to resistance near 2,940 over the next one to three months, but big days sometimes include warnings signs that a durable bullish pivot has not been completely established and that there may still be some short-term volatility to work out. In my opinion, The Tuesday through Wednesday rally is still at a high risk of being a temporary fakeout.

S&P 500

The S&P 500 continued the rally earlier today and interacted with the neckline of the recent head and shoulders pattern. From a technical perspective, the neckline is a key inflection point where traders will watch for a breakout.

The issue at this level is that, if the market fails to break higher and starts to fall again, it will be seen as a much more reliable bearish signal. A completed head and shoulders pattern followed by a move back to the neckline and then another move lower is also known as a "retest." A head and shoulders pattern retest was the same sequence of events that preceded the big decline in 2008.

On the other hand, I could be a little too cautious here, and I think a confirmed break back above the neckline would do a lot to increase my confidence that the market is ready to pivot higher. I expect that we will all know which scenario is playing out by this Friday.

Risk Indicators – Oil's Bear Market

From a risk perspective, most indicators performed the way I would have expected on Tuesday and Wednesday and reflected a slightly improved outlook. However, I was disappointed to see a lackluster move in energy prices. As a proxy for global growth expectations, rising oil prices could do a lot to improve investor sentiment.

As you can see in the following chart, West Texas Intermediate (WTI) oil futures prices have entered a full bear market by falling more than 20% from the April highs and have shown little bullish momentum over the past two days despite stock market bulls. A bounce at this level in oil prices could be an early indicator for positive movement in the stock market, including small-cap stock indexes, which tend to overweight oil companies and related industries.

Bottom Line – Will Congress Cool Off Some of the Uncertainty?

The real lesson of the past few weeks is that the market seems to be reacting mostly to government action rather than fundamentals. A tariff tweet from President Trump will send prices plummeting, while a speech about monetary policy by FOMC members sends prices back up.

Unfortunately, government interference in the market is inherently unpredictable, which will continue to make trading a little tricky in the short term. However, in my experience, politicians seem to have little appetite for self-inflicted down days in the market, so there could be an opportunity here to cool things off from a tariff and trade perspective.

I don't expect to see that happen this week; by Monday, when new tariffs are supposed to be imposed on Mexican imports, I would not be surprised to see a significant de-escalation in the trade threats. Opposition in the Senate to more tariffs could provide a pathway to reduce some uncertainty and create an environment for a more sustained rally in the major stock indexes.

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