S&P 500: Time for a short inception? ($SPY $SPX)

By Patricia Miller


Consider shorting the S&P 500 cautiously. Understand economic indicators, corporate earnings, and market sentiment for potential gains and losses.

Pixelated Short Selling sign on stock screen.
Time to Short the S&P 500?

In the stock market, the S&P 500 stands as a benchmark for financial health and investor sentiment. With recent market fluctuations and economic indicators pointing towards potential shifts, retail investors in the US and Canada are now facing a crucial question: Is it time to consider shorting the S&P 500?

Short Selling

Short selling involves borrowing shares and selling them at the current market price, with the intention of buying them back at a lower price. This strategy profits from a decline in a security's price. While it can be lucrative, it also carries substantial risks, as losses can exceed the initial investment if the market moves contrary to expectations.

How Does Shorting Stock Work?

When someone holds a long position, it means they own a security with the expectation that its share price will rise, allowing them to profit from the increase. On the other hand, shorting a stock involves borrowing shares and selling them with the hope that their price will decline. This strategy can be executed through a margin account, where traders essentially borrow money to short the stock.

However, it's essential to be cautious when shorting stocks, as it comes with its own set of risks. A short squeeze, for instance, occurs when a stock's price unexpectedly rises, forcing those with short positions to buy back shares at a higher price to cover their positions. This can lead to significant losses. 

Money Managers Shorting the Market Have Lost Big

In November 2023, the stock market witnessed a substantial surge, causing hedge funds to incur approximately $43 billion in losses due to their bets on declining stock prices. This data is sourced from a Financial Times report referencing S3 Partners data.

Hedge funds and money managers who had short positions on U.S. and European equities were taken by surprise as the market rallied. This rally was fueled by optimism that the Federal Reserve might halt its interest rate hikes. Notably, the S&P 500 saw an impressive gain of over 7% in November, making it the best-performing month since July 2022.

Not All Short Sellers Are Bad! In Fact, They Do Some Good

Institutional investors who had bet against companies expected to struggle in a high-interest-rate environment are now grappling with unprofitable trades, thanks to renewed market confidence. Some hedge funds found themselves in a "short squeeze" situation, compelling them to buy back stocks, thereby driving share prices even higher.

Additionally, a Goldman Sachs index tracking S&P 500 companies with high short interest is on track for its strongest month since October of the previous year.

DataTrek Research strategists analyze large-cap sector correlations and interpret them as an indicator of a continued uptrend in stocks until the year-end.

They assert that low correlations, indicating selective sector and stock investments by investors, signal positive market conditions. In contrast, high correlations are typically seen during recession concerns, leading to broad equity sell-offs. In light of these trends, the strategists maintain a bullish outlook for U.S. equities in the upcoming weeks.

Understanding the Market Dynamics

The S&P 500, a collection of 500 of the largest companies listed on stock exchanges in the United States, offers a broad snapshot of the market's health. Understanding market dynamics is crucial in the current environment, where there are significant fluctuations in capital markets and commodity prices. Higher volatility indicates greater risk in securities.

According to the S&P Global Market Dynamics, the S&P 500 outperformed the S&P 500 Low Volatility Index, rising 3.7% from Aug. 18, 2023, to Nov. 17, 2023, while the latter declined by 0.4%. This divergence can occur during periods of strong S&P 500 performance and low volatility, with the S&P 500 having a relatively low 13.6% annualized daily standard deviation.

Volatility decreased across all 11 GICS sectors from July 31, 2023, to Oct. 31, 2023. The Energy sector saw the most significant reduction in volatility but remained the most volatile at 24.9%. Consumer Staples had the lowest volatility at 11.6% as of Oct. 31, 2023.

The latest rebalance of the S&P 500 Low Volatility Index led to notable changes in sector weightings. Health Care's weight decreased by 6.4%, while the Consumer Discretionary sector's weight more than doubled to 7.3%.

Information Technology's weight almost doubled to 4.2%, and the Consumer Staples sector increased its weight to 26%. The Energy sector received a small allocation of around 1%, leaving the Materials sector as the only one with no allocation in the index. The rebalance was effective after the market closed on Nov. 17, 2023.

How Can Institutional Share Ownership Be Over 100%?

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Beware the Santa Rally

The "Santa Claus rally" phenomenon typically leads to increased buying activity towards the end of the year. While this doesn't call for aggressive trading, it suggests a "buy the dip" approach may come into force.

Keep a close eye on the 4500 level on the S&P 500 and the 50-Day EMA just below it. Many traders regard the 50-day EMA as a potential support level for the market. Even if it breaks, substantial support is anticipated around the 4400 level. Shorting the market before year-end is challenging due to Wall Street's focus on liquidity over the global economy's actual state.

Rather than shorting, consider waiting for opportunities to acquire stocks at lower prices. Remember that the "Magnificent 7," comprising 28% of the S&P 500, significantly influences the index. The market behaves like an ETF due to its weight.

While there are signs of market overextension and economic concerns, prevailing dynamics and the influence of major stocks suggest a preference for buying on dips. Approach year-end cautiously, monitor key levels, and watch broader economic indicators.

Why Consider Shorting the S&P 500 Now?

Some factors making investors consider short selling include:

  • Economic Indicators: Metrics such as GDP growth, employment rates, and inflation can impact investor confidence and market trends.

  • Corporate Earnings: If a significant number of companies in the S&P 500 report lower-than-expected earnings, it can lead to a broader market decline.

  • Market Sentiment: Investor sentiment, often swayed by geopolitical events and policy changes, plays a critical role in market movements.

Risks and Rewards

Shorting the S&P 500, particularly through ETFs like $SPY or the index itself $SPX, requires a careful assessment of risks and rewards. The potential for high returns exists, but so does the risk of significant losses, especially in a market known for its resilience and tendency to rebound.

Strategies for Short Selling Investors considering this approach should:

  • Conduct Thorough Research: Understand the factors influencing the market and the specific securities being targeted.

  • Set Clear Goals and Limits: Define what success looks like and establish stop-loss orders to mitigate potential losses.

  • Stay Informed: Keep abreast of market news and trends, as the stock market can be highly reactive to new information.

To protect themselves from potential losses when shorting a stock, some investors buy a put option, which gives them the right, but not the obligation, to sell the stock at a predetermined strike price if its price drops. Failing to do so can result in a margin call, where the broker demands additional funds to cover potential losses. 

While short selling can offer the potential for profits in a declining market, it's important to approach it with caution, as the stock market is known for its volatile price movements, and the obligation to sell at a higher price than anticipated can lead to substantial losses for those who are not prepared. 

Shorting the S&P 500 is not a decision to be taken lightly. It requires an understanding of market dynamics, a clear strategy, and an acceptance of the risks involved.

Relevant ETFs

Some investors prefer to invest in stocks via an exchange-traded fund for ease and reduced risk. Some popular ETFs include the following:

  • Large-Caps: Vanguard Mega Cap ETF (MGC)

  • Mid-Caps: Vanguard Mid-Cap ETF (VO)

  • Small-Caps: Vanguard Small-Cap ETF (VB)

  • Growth: iShares Core S&P U.S. Growth ETF (IUSG)

  • Value: iShares Core S&P US Value ETF (IUSV)

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Author: Patricia Miller

This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment. Past performance is not an indicator of future performance.

Digitonic Ltd, the owner of ValueTheMarkets.com, does not hold a position or positions in the stock(s) and/or financial instrument(s) mentioned in the above article.

Digitonic Ltd, the owner of ValueTheMarkets.com, has not been paid for the production of this piece by the company or companies mentioned above.

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