David Jones looks at how far the current stock market rally might go – and how to profit if this is just a very exaggerated ’dead-cat bounce’.
It has been quite a month for financial markets. It is difficult to know whether to start with the oil price going negative or stock markets continuing to defy gravity when faced with the prospect of the largest recession in almost a century.
The recovery has been as dramatic as the plunge
It is often said that ’bull markets climb a wall of worry’. While the stock market is rising, plenty of investors are always nervously looking over their shoulder waiting to see what is going to cause it to stop. And of course, now we know the answer. The spread of the coronavirus stopped stock markets in their tracks and triggered sharp falls which were particularly rapid by the standards of recent history – the FTSE 100 index dropped by more than a third in value in less than one month.
FTSE 100
But what has been equally surprising is the rate of the recovery. From a low point of 4,900 in the middle of March, the FTSE 100 index was one thousand points higher six weeks later. In the US, this recovery has been even more impressive with the broad S&P 500 index rallying by more than 30% off its March low.
S&P 500
Why so strong?
This is great for investors but has left many still scratching their heads. According to the International Monetary Fund, the world is facing an economic decline as bad as the Great Depression in the 1930s. Has the stock market really factored all of that in and decided that a strong bounce-back off the lows is the answer?
There will be plenty of people who think that the stock market reaction is wrong – and many of these people will have had their fingers burned trying to call the top. But given the near vertical rise of stock indices over the last few weeks, there is still perhaps an opportunity to profit if you believe this is over-extended.
The mechanics of short-selling
Some people will tie themselves in knots trying to understand short-selling – but it really is not very complicated. Think of it the same as buying low and selling high – but just where those actions are reversed.
If someone thinks a market – let’s say the price of gold − is too high, then in financial markets you can sell something you do not own − with the aim of buying it back lower. So, if gold is trading at $1,700 per ounce and you sell short, if you buy back to close your position at, for example, $1,600 per ounce, then you have profited. Of course, if you are wrong and the gold price climbs to $1,800 and you want to get out of your short then that will represent a loss.
Traditionally it was difficult for private investors to short-sell – but with spread betting, a major benefit is that you can trade markets in both directions. At the time of writing, with the FTSE nudging near to the 6,000 mark, if you thought it was going to go crashing back to those March lows below 5,000 there is more than one thousand points of profit potential in that trade.
Are stock markets about to plunge again?
Before you rush to sell, as the FTSE obviously should not be trading so high with a global recession around the corner, let’s just pause to take stock.
Lots of people – including professional and retail traders – have been selling this rally all the way up because, amongst other reasons, ’it makes no sense’. And that is a fair opinion – I don’t think many of us would have expected the major global stock markets to bounce back so fiercely over recent weeks. Lots of traders have been early to call the top in this recovery and have paid the price with their wallets.
On the face of it, it does not make sense that the US stock market is up by a third in not much more than a month. An extra 26 million Americans have filed for unemployment benefits since then; the global economy is in limbo as so many countries have been in lockdown; actions by both central banks and governments are keeping things ticking over in a sort of suspended animation state; and when lockdowns are lifted it will not be like pressing a reset button − the economy is not going to be the same as it was in January.
None of this is a secret – and the stock markets have still recovered well. One argument could be that once again the central banks have come to the aid of the world economy and bailed it out with lower interest rates and increased quantitative easing. Governments have done their bit too. Here in the UK, furloughed employees are having a significant percentage of their salaries paid by the government to avoid redundancies. The uncertainty has been taken away – someone will always step up to save markets and economies from crashing.
While that is one viewpoint which so far you could argue has been borne out by the market-price action since the March lows, no-one really knows how bad the economy will be when we get back to something approaching ’normal’ in our everyday lives and businesses. With some countries starting to ease lockdown restrictions, we could have more data to go on soon and that is something that could take the wind out of the saies of markets.
Stock-market levels to watch
If we look at the widely followed US Dow Jones index, the size of the recovery from those lows is around 6,000 points so far since the absolute coronavirus-driven low on 23 March. At the time of writing, it is a market that is still strong and could conceivably push higher still.
Dow Jones Industrials
The interesting band to watch at the moment is from June 2019 through to November of the same year. The market was trading in a wide range from 24,500 to 27,500 until it took off once again in what is now the last surge of exuberance before the virus really took hold. I think this wide band is the zone to watch for any weakness – I also think that if the high at 27,500 is taken out, then the obvious target is for a run back to the old all-time highs above 29,500.
So the patient short-seller will be waiting for a sign of weakness here and not blindly trying to call the top in what has so far been a very strong rally.
Trade example
As an example, if the market pushes back to 25,000 and has a reasonable period of time – for example, more than a week of not being able to set fresh highs for the recovery – this could be the sign that the momentum is finally fading and it is time to sell short. If the bearish trader is looking for a sizeable move down, then any stop loss will need to be relatively wide, to avoid getting taken out in just the day-to-day noise of these very volatile markets. Looking back over recent moves in the Dow Jones index, a 500-point daily range is not that uncommon at the moment, so I would say, do not be deterred by placing a stop loss some distance away. As a ‘finger in the air exercise, let’s pick 1,000 points. This may seem absurd, but over the past week that is the amount the Dow Jones index has rallied. If you are trying to catch a major move, you need to give the market time to chop around.
One week, one thousand points
Short-selling via a spread bet at 25,000 with a stop loss at 26,000 is one idea − if the market has started to show signs of running out of steam. When it comes to the size of the trade it is completely up to you and dependent on your overall financial position and how much money you have dedicated to shorter-term trading. Plenty of spread betting companies let you trade from pennies per point; if a trade was opened at, for example, 50p per point with the stop a thousand points away, then clearly the financial risk in this case is £500.
It has been a fascinating year so far for stock markets – and of course painful for many of us as investors. The size of the recovery has been unexpected and with so much still unknown there should be plenty of volatility still to come in 2020. Short-selling should be an important tool for any active trader in these markets and it is very easy to do using spread-betting.