Rebalancing and Short-Covering May Lead to a Market Rally
US stocks closed very strongly last week, up over 20% in three days trading.
Most investors have attributed the strength of the rally to optimism around the imminent US$2 trillion economic stimulus package. But one strategist at JP Morgan (JPM) says the rally’s underpinnings are less driven by economic and political fundamentals than some may believe.
“The initial stage of this rally is being driven by rebalancing and short-covering,”
Pension funds and mutual funds are required to maintain a predetermined asset allocation of equities and bonds. Due to the massive rally of bonds in recent months and consequent underperformance of equities, funds are being forced to reallocate their positions by selling bonds and buying equities.
Panigirtzoglou believes this will lead to an $800-900 billion injection into equities in the coming weeks. To put this into perspective, the total value of global equities traded on average daily is only around US$84 billion, so there is still considerable upside potential to profit.
The end of quarter rebalancing will conclude this Tuesday (March 31) so don’t be surprised to see the market pop just prior, with investors trying to take advantage of this short-term tactical opportunity.
Another key reason for the recent equities rally has been a huge spike in short-covering from long-short equity funds. By closing out their positions through the purchasing of stocks, hedge funds have taken full advantage of the anaemic equity markets caused by the impacts of COVID-19, and are locking in profits.
Panigirtzoglou stated that that we are likely to see considerable short-covering from here if the “impact from the virus turns out to be less long-lasting or that measures taken by policymakers to support demand prove larger in magnitude than the equity market envisages”.
The medium to long term impact of COVID19 is still unknown. But by understanding the structural makeup of markets, astute investors like Panigirtzoglou are still able to cash-in on short term tactical opportunities.