Inside Markets — Pain Trade Higher

Last Monday’s close in the SPX and RTY triggered bullish momentum divergence signals when both indices were at short-term oversold levels. The SPX also closed the post-election upside gap that same day, which made the bullish tactical call a bit easier. Our conviction increased last Thursday when data from the prior week showed the bulk of January inflows finding their way to money market funds rather than equity/fixed income markets. The most inclusive data set comes from EPFR, which had money market balances reaching a record high of $8.2T last week. More contrarian signals emerged that same morning after AAII bearish sentiment from the prior week reached elevated levels as Q4 earnings prints from major US banks and other early prints (NFLX) came in better-than-expected. Individual investors (typically wrong at extremes) weren’t the only ones caught offsides as mid-month data revealed hedge funds added leverage to become net short. The likely rationale for the caution was post-inauguration headline risk (tariffs) that has yet to materialize. The most recent AAII polling data had equity sentiment at a more neutral level, while hedge funds have spent the week hunting for liquidity to cover net-short positioning. The predictive signal from momentum divergences begins to fade after three or four weeks, but the near-term pain trade remains higher in our view as the corporate buyback window reopens next week for 45% of the SPX market cap and vol-targeting strategies add length. Of course, much of this depends on next week’s earnings prints with 40% of the SPX market cap scheduled to report, including reports from MSFT, META, AAPL, AMZN and TSLA.