The rebound in US stocks is not a vote of confidence! Short covering creates a "false prosperity" and the upward trend may be hard to sustain

According to Zhitong Finance APP, as the U.S. stock market rebounds from a sell-off amid lingering uncertainty, there often lurks an aggressive buyer behind the rally—short sellers forced to cover their positions. Taking the "most-shorted stocks basket" compiled by Goldman Sachs as an example, this index has surged 16% since the beginning of this month, far exceeding the S&P 500 index's 0.7% increase during the same period. According to data since 2008, this performance positions the basket of stocks to potentially achieve the strongest October performance on record.

Thomas Thornton, founder of Hedge Fund Telemetry, stated, "Shorting this market is really difficult because this rebound seems like it will never end." "The feeling of getting slapped in the face by the market every day is both painful and demoralizing." It is reported that he holds a small net short position on the S&P 500 index and the Nasdaq 100 index.

Over the past six months, the S&P 500 index has largely ignored all warnings, achieving one of the strongest phase performances since the 1950s. Since the beginning of this month, the rare contrast between the S&P 500 index and the "most-shorted stocks basket" indicates that some investors are covering their short positions ahead of the Federal Reserve's next interest rate decision on October 29.

Although such aggressive covering actions typically push the overall market higher, this dynamic may create a false sense of "confidence voting." In reality, the market remains uncertain about U.S. President Trump's trade agenda or the direction of Federal Reserve policy.

Entering October—the historically most volatile month—derivatives market data shows that traders previously paid higher premiums to hedge against "sharp rises" rather than "sharp declines." However, this trend is changing.

While the S&P 500 index rose 1.7% last week, risk aversion has now intensified. Mandy Xu, head of derivatives market intelligence at Cboe Global Markets, wrote in a client report on Monday that traders are raising funds by selling call options to purchase downside protection.

Thomas Thornton pointed out, "Everyone is betting that the Federal Reserve will cut rates again, but many are overestimating the impact of rate cuts on the economy, as policymakers may not be able to significantly lower borrowing costs as Wall Street hopes."

Despite experiencing multiple fluctuations recently, the S&P 500 index is less than 0.3% away from its all-time high. Previously, the White House hinted at smooth progress in trade negotiations with China, and strong earnings reports from several regional banks alleviated market concerns about credit risk. On Monday, the Cboe Volatility Index (VIX)—a measure of implied volatility for the S&P 500 index—has fallen back below the critical 20-point mark after briefly touching its highest level since April last week Currently, both quantitative trading programs and individual investors are reducing their exposure to U.S. stocks, primarily due to the unusual divergence they observed this summer. At that time, systematic quantitative funds based on momentum and volatility signals were bullish on stocks, while subjective investors making judgments based on economic and earnings trends remained cautious.

However, overall stock positions saw the largest weekly decline since the massive sell-off in early April last week, falling from "modestly overweight" to "neutral." A team led by Deutsche Bank strategist Parag Thatte pointed out that subjective investors have currently shifted from neutral to a clearly underweight position. However, this also leaves ample room for them to return to the buying camp in the future.

Parag Thatte stated, "Subjective investors have a lot of room to maneuver and will ultimately increase their stock exposure and buy on dips. They are still concerned that the economy or corporate earnings may face issues, but if corporate earnings remain strong, they will ramp up their buying power in U.S. stocks again."

Quantitative traders using systematic strategies have reduced their positions from higher levels to moderately overweight. The stock exposure of trend-following funds (CTA) fell again last week, dropping to the 83rd percentile of its multi-decade range, the lowest level in three months.

Parag Thatte added that if CTAs' next move is to take profits and unwind extreme positions, it could lead to a temporary pullback in the stock market in the short term, but the S&P 500 index would need to drop at least 3% to 5% from current levels to trigger a large-scale sell-off by CTAs.

Meanwhile, the most speculative sectors in the market have been soaring. Goldman Sachs' "unprofitable tech basket"—which includes companies like Roku (ROKU.US) and Peloton Interactive (PTON.US)—has also risen 16% since October, and according to data since 2014, this basket of stocks is also expected to achieve its best October performance ever.

Thomas Thornton stated, "If investors flock to these speculative sectors that are highly correlated with the most shorted stocks, they are actually taking on higher risks and ignoring the fundamental reasons these stocks are being shorted. The risk of a market pullback could come at any time. The specific trigger is unpredictable, but the question is not 'if,' but 'when.'"