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When everyone is selling, it creates an opportunity to buy cheaper. This is how uptrends recover. However, sometimes the rise in asset prices after widespread sell-offs is merely the result of short sellers covering their troubled positions. If that's the case, the bullish trend is not necessarily resuming. Something similar is currently happening with the S&P 500.
According to research from Goldman Sachs, short sellers of U.S. equities covered their positions in October at the fastest pace on record since tracking began in 2008. It was their activity that brought the S&P 500 back to near record highs. But if this is not a case of buying the dip, there are serious doubts about the bulls' ability to reestablish a sustained trend.
For a long time, the broad stock index has ignored negative developments, while many good news events are already priced in. U.S.–China trade talks have resumed. Derivatives markets are fully pricing in a rate cut by the Federal Reserve by the end of December. The U.S. government shutdown prevents a proper assessment of the economy's strength. All that's left is the third-quarter earnings season.
Thus far, things appear favorable. According to FactSet, 76% of reporting companies have exceeded profit forecasts. Notably, positive results from Coca-Cola, 3M, and General Motors helped the Dow Jones Industrial Average to reach new record highs.
Earnings growth significantly contributes to equity value expansion. However, when the S&P 500 rises this high, thoughts of a bubble become inevitable. What could cause it to burst?
First and foremost: failure of the U.S.–China negotiations followed by a full-blown trade war. A much stronger-than-expected surge in U.S. inflation in September could undermine expectations for a Fed rate cut in October. Finally, the earnings season might start strong but end poorly. Who can guarantee that tech giants will satisfy investor expectations for Q3?
Indeed, if the S&P 500 reaches new record highs, fresh buyers will join the rally. But if the broad-based index fails to break through soon, consolidation and elevated volatility can be expected. As a result, October may live up to its longstanding reputation as the most volatile month for U.S. equities.
A transition of the S&P 500 into a trading range would shift attention to other markets. The carry trade has lifted Japan's Nikkei 225 and TOPIX, while the resolution of France's political turmoil has pushed the CAC 40 to a new record.
From a technical perspective, a doji bar has formed on the daily chart of the S&P 500 following a wide-bodied candle. A decline below the 6,720 level could signal the start of a bearish reversal pattern. Consider short entries from this level.
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