What The Next Decline Will Likely Tell Us

By Benzinga | June 10, 2014 AAA

Even the most ardent bulls will have to admit the current joyride to the upside might be getting a little out of hand.

For example, the S&P 500 has finished higher 13 of the last 16 days and 11 of the last 13. Since David Tepper made his comments about not being "too frickin long" here, the S&P 500 has gained 4.2 percent and has broken out to new all-time highs on nine separate occasions.

In short, the blast higher has been impressive and caught a great many investors leaning the wrong direction. The chart below says it all;  as there is no denying that the bulls are once again large and in charge.

 

S&P 500 - Daily
spx_daily.png

 

So, what do the fast-money traders do when they are on the wrong side of a runaway train? Short the SPDR S&P 500 Trust (NYSE: SPY), of course!

Shorts Loading Up, Again

Traders who tend to see the glass as at least half-empty have had a rough go of it, ever since all the talk of the "fiscal cliff" back in 2012. Yet, according to Bloomberg, those in the bear camp remain steadfast in their view that stocks must fall -- and soon.

Related: The Markets' Continued Climb On The 'Wall Of Worry'

Bloomberg reported Monday that shorts on the SPY have reached nearly 11 percent of the shares outstanding, which is the highest proportion of short sales to shares outstanding since 2012. Bets against the XLK (Technology Select SPDR) are now 67 percent above the average seen over the last 12 months.

One can then surmise that the bears are reloading their short positions in response to the S&P 500 marching higher into new-high territory. The thinking is that, with the market now extended and overbought, it is time for a pullback - and everybody knows it.

So What Comes Next?

History shows that one of two things are about to happen in the near-term. Either the much-anticipated pullback becomes a self-fulfilling prophecy, where the sellers have their way with the indices for a few day, or the bulls continue to romp, the shorts capitulate, and the market spikes even higher.

Experience suggests option number one might be preferred, as most "blow off" phases don't end well.

At this stage, any decline lasting more than a couple hours would likely be welcomed by a great many market players. How the market reacts during a pullback, a consolidation, a correction, or a "sloppy phase" can reveal a lot about what comes next.

The Way the Market Declines Will Indicate...

The way the market acts during the next decline will reveal a lot about how much gas the bulls have left in their tank -- and whether or not the current leg higher has staying power. 

Stocks are at all-time highs and the shorts are pressing their bets that the market will soon decline. Should the S&P pull back a couple percent or so without any really scary news, the shorts will likely take whatever gainsthey might be able to eke out on the trade and feel good about it. The bulls would then buy the dip and the market could continue to stair-step higher.

In other words, a shallow decline without a lot of conviction on the downside would be a signal to the bulls that it's time to buy the dip again.

However, if the bears can come up with a raison d'être and create a nasty spill in the indices, the game could easily play out differently.

If there is a decent catalyst and some participation on the downside, then the sellers may be able to convince the buyers that it would be best to "stand aside" for a while. After all, up until three weeks ago, 2014 had been the year of the "breakout fakeout."

So if there is any indication that a new crisis is emerging, the buyers might become very shy about putting capital to work in a market that is extended on many levels.

But which will it be? Will the market see a mild pullback which inspires the bulls to buy the dip, or something more grizzly in nature that scares the heck out of everyone? Or will the bulls just keep on keepin' on, forcing all of those shorts to cover in an explosive upside surprise?

Stick around, this is probably going to be interesting.

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