Hoping Overbought Gets More Overbought, Traders Positioning For Santa Rally

With investor sentiment elevated and help from the Fed, margin debt, and foreigners, major US equity indexes remain near highs. Bulls are positioning for a Santa rally, followed by the onset of 4Q earnings season in the first half next month. How stocks behave leading up to/during this will be a tell as to if unwinding of overbought conditions begins sooner than later.

As of last Wednesday, the Fed held $7.36 trillion in assets, up $3.2 trillion in the past 10 months. In between, holdings of mortgage-backed securities and treasury notes and bonds went from $3.40 trillion to $6.04 trillion.

Since March, the Fed has an open-ended quantitative easing (QE) program in place. Speaking to the press at the end of the year’s last FOMC meeting last Wednesday, Chair Jerome Powell said the central bank would adjust its QE if the need be, but for now, would purchase at least $120 billion/month in US treasury bonds and mortgage-backed securities. At this pace, these assets are on pace for $6.82 trillion in the next six months.

This could have implications for stocks – at least equity bulls hope so. During the financial crisis, there were three iterations of QE, with the first getting underway in December 2008. During each of these, the S&P 500 closely tracked the beginning and end of QE. Even this year, after a nasty sell-off in February and March, the large-cap index (3709.41) bottomed on March 23 at 2191.86; even though its balance sheet had been trending higher since September last year, the Fed announced its unlimited QE on that precise date.

Hence the question, will the red line follow the green line in Chart 1 higher in months to come?

Investor optimism remains elevated. The central bank’s aggressive purchases of these securities is not the sole reason for this but it cannot be hurting either.

Chart 2 plots investor sentiment reflected in how newsletter writers and professional money managers feel currently, with the first measured by Investors Intelligence’s survey and the latter by the National Association of Active Investment Managers’.

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