Setup for a Q2 Squeeze Play
Our model is a 2 factor model (with a little seasonality sprinkled in for good measure.) The 2 factors are sentiment and price action. Because it is a 2 factor model, we wind up with four (2 squared) type classifications. This is because we focus on the extremes of each factor. For sentiment, we determine a majority of either bulls or bears. Price action in its simplest form is either up or down. The following diagram shows the dynamic of our four Type classifications:
A short squeeze (Type 1) is when we observe heavy short selling and price uptrends.
More often then not, the shorts get squeezed out by rising prices, helping to build a majority of bulls. For the duration of rising prices after the shorts are squeezed out, the bulls will profit from rising prices - Type 2 (bulls are right.)
At some point, usually when bullish sentiment is excessive and the majority is long, price action will deteriorate, putting the Type 4 (long squeeze) into play.
As prices decline, long stock holders sell out (usually near a significant low) and short interest begins to build. For the duration of falling prices after the longs are squeezed out, the bears will profit from falling prices - Type 3 (bears are right.)
At some point, usually when bearish sentiment is excessive and the majority is short, price action will improve, putting the Type 1 (short squeeze) back into play, and the whole cycle begins anew.
In January 2005, we griped a bit because we failed to see significant bearish sentiment. Even now the VIX (CBOE Volatility Index) is historically low, and market advisors remain mostly optimistic. That's a problem for the secular posture of the market, which remains poor. However, last month's increased short selling, especially in key sectors, is a source of fuel for a potential Q2 rally:
In the third quarter of 2004 we observed that short intensity for technology issues was heavy. Price action then improved, causing a rally for technology into the fourth quarter of 2004. That rally squeezed out the shorts. Subsequently the price action of technology issues lapsed into this year. Now that we see heavier short selling once again, we anxiously await improvement in price action.
The above chart shows the percentage of issues in the electronic technology sector that are Type 1s (short squeezes) and Type 3s (shorts are right). This "Type" diagram shows that Type 3s typically precede Type 1s - the arrows from the peaks in percentage Type 3s to the peaks in Type 1s slant forward in time. This is proof that most build-ups in short selling get squeezed out by higher price action.
We believe the current market is now in that period where Type 3 issues are setup to become Type 1, short squeezes - in most sectors. This March, some more negative action may have built short selling up to even higher levels. We get a fresh read on short interest data next week. The fact that the market decline is relatively moderate, coupled with the improved seasonality ahead, allows us to anticipate a Q2 rally.
Energy issues have been in a well established bull market. Over the past few years, there have been many squeezes of Type 3s into Type 1s. Currently, there are few Type 3s, but still many Type 1s. We continue to watch the level of Type 1s in energy - a fall off without a build-up in Type 3s would indicate a maturing of this bull trend. Stay tuned.
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