This looks a lot like late 2021

It started as the “magnificent seven” driving the stock market rally but has morphed into a single stock, Nvidia, driving global equity prices. This phenomenon has become so extreme that when we talk about the major indices, S&P 500 or NASDAQ 100, we are essentially talking about Nvidia! This is not natural, nor the sign of a healthy market. As a futures and options broker, I rarely mention individual stocks, but the current environment demands it, which in itself has me raising an eyebrow. We must wonder if this type of manic euphoria over a single stock (that few can articulate what products they provide) is sustainable. We saw something similar in the fall of 2021; Tesla stock’s cult-like buyers generated a parabolic rally, taking the indices for a ride. Tesla has never regained those highs, and the NASDAQ 100 has just recently managed to do so. Here are a few of our thoughts on the current situation.

On an aside, we talked about this on Bloomberg Television last Friday.  Check our website to view the archive.

Nvidia Earnings were the perfect storm of chaos

As is always the case, corporate earnings are released before or after the bell. I’d ask why this is the case, but I know the answer – It has always been that way, and tradition is difficult to alter even if it is logical to do so. Humans are creatures of habit, and change is generally unwelcome. Nevertheless, announcing game-changing data for each reportable company while trading on domestic stock exchanges are, for all intents and purposes, closed is undesirable at best. At worst, the practice of hitting a thinly traded market with substantial news is a recipe for disaster. The price discovery process is messy enough; additional obstacles are unnecessary. Some traders do have access to after-hours stock trading, but not everyone does, so it feels unfair to some market participants.

In addition to the news being released into a low liquidity environment after the mainstream media, finance bloggers, and fintwit accounts pumped it up, the earnings report came on the heels of a market sell-off that invited the bears to pile into short positions and encouraged some complacency. It is worth noting that stock market bears, particularly tech stock bears, have suffered since October 2023. The October lows occurred in an environment where most economists were still looking for a recession, most stock analysts were calling for lower prices, and the retail crowd was fearful. The circumstances were ripe for a bottom, but many market participants were prepared for the opposite. This matters because, with the S&P 500 above 5,000 and the NASDAQ 100 flopping on both sides of 18,000, the bears are trading with limited capital and “scared money.” This means they are more fickle, and their pockets are shallow; in other words, they are more susceptible to short squeezes.

Nvidia short sellers and speculators were buying Nasdaq 100 futures

Questionable liquidity and limited access to Nvidia shares in aftermarket trading triggered massive volatility and, eventually, buying in NASDAQ 100 futures. As mentioned, the NASDAQ 100 and Nvidia have become highly correlated, so it makes sense for those seeking an open and liquid marketplace to either offset or take risk to use NASDAQ 100 futures. The stock index futures trade mostly around the clock; they close for an hour in the afternoon but otherwise trade through earnings reports, overnight geopolitical events, etc. Thus, it is a great idea for everyone to have access to such products should the need arise. If you haven’t already, I suggest getting a futures account set up so it is there if or when you need it (shameless plug – www.DeCarleyTrading.com). After all, the futures markets were created to provide a viable means of hedging price risk.

That said, anyone participating in futures and options for speculative purposes, should be aware of the good, the bad, and the ugly of leverage. Just because leverage is available doesn’t mean it should be used aggressively. In fact, less is more; a trader can eliminate leverage from futures products by funding an account with enough cash to cover the nominal value of the contract being traded. For example, in the traditional E-mini S&P 500, that is currently about $280,000, but in the Micro E-mini S&P 500 futures, it is about $28,000.

Although stock index futures are reasonably liquid for their entire 23-hour trading session, they are less liquid in the last hour of trading (when earnings are typically released) and in overnight trading. Thus, the influx of market activity profoundly impacted price (arguably more than would have been the case were earnings reports released during the traditional day session). This seems to have triggered a gamma squeeze in which market makers who had sold calls to retail traders, or even those selling calls to collect what previously seemed like attractive premiums, were forced to buy futures to hedge their option risk. You might recognize this phenomenon; it was one of the primary driving forces of the meme stock rallies a few years ago. Consequently, traders waiting for the NYSE and NASDAQ to open the following morning to either exit or adjust positions were put in a stressful scenario of chasing prices, which likely exacerbated volatility.

Prices are temporary, particularly short squeezes

Bloomberg News ran a story outlining the billions of dollars in losses experienced by short sellers in Nvidia stock last week. As stunning as parabolic short squeezes are, they are often temporary. This is because, by definition, a short squeeze is an environment in which buyers are doing so because they must, not because they want to. They are likely motivated to buy for reasons such as margin calls, cash crunches, panic, pain, or all of the above. These buys are not occurring en masse because traders have a positive outlook on the underlying security, instead, most of the buys are resulting from traders who had a negative outlook on the stock being, at least temporarily, proven wrong.

Nvidia is not a meme stock, but it is acting like one and taking the rest of the market for a joy ride. Excessive call option buying is indicative of speculators running amok. We’ve all seen how this ends, but unfortunately, we can’t see when or where it ends until it does. In a recent letter to shareholders, Warren Buffett stated, “For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young.” As complacent and exuberant speculators learned with GameStop (I recommend the Netflix documentary Eat the Rich: The GameStop Saga, if you haven’t already seen it), but some have forgotten, the house always wins.

Nasdaq 100 monthly chart

The NASDAQ 100 chart suggests the rally is overheated based on standard technical oscillators regardless of the daily, monthly, or weekly time frame. Further, the RSI (Relative Strength Index) is diverging from the markets (as the NASDAQ 100 makes new highs, the RSI is not following). This doesn’t guarantee prices experience some mean reversion selling, but the odds strongly favor such. We have shared this chart multiple times in recent weeks, but we don’t mind sharing it again.