Stock Traders' Enthusiasm Returns to Levels Seen Just Before Last Year's 10% Drop

Traders' overwhelming enthusiasm for stocks has started to raise concerns among a team of Citigroup strategists. According to Chris Montagu, Citi’s global head of quantitative research, and his team, net-long positioning in S&P 500 futures has hit its highest level since July 2023. This is making them nervous, as similar bullish positioning last year was followed by a significant downturn in the stock market.

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Back in July 2023, the overconfidence in stock positioning led to a harsh selloff that dragged the S&P 500 down by 10% over the following three months. Now, Montagu is worried that investors could be setting themselves up for a repeat of this situation. He cautioned that while there’s no immediate need to reduce exposure, the risks increase when market positioning becomes this extended. The Citigroup team highlighted that stretched market conditions raise the likelihood of a pullback, even though they are not yet urging investors to scale back.

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In contrast to the S&P 500, positioning in Nasdaq-100 futures isn’t nearly as extreme. This index remains far removed from the frothy levels seen in July 2023 and again in July 2024. The Citi team noted that short-covering in S&P 500 futures, where traders buy back shares they had borrowed and sold to close their positions, may have contributed to pushing the market even higher in recent weeks. Short covering typically leads to an increase in stock prices as traders scramble to buy back shares to avoid further losses.

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A key distinction between the current market environment and that of the summer of 2023 is that investors’ profit-and-loss statements are not as strained now, Montagu pointed out. This suggests that investors may be less inclined to sell off stocks to lock in gains or avoid further losses. In 2023, many investors were more likely to offload shares to protect their profits, a dynamic that may not be as strong this time around. However, the potential for profit-taking still looms as a risk.

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Another factor potentially driving the market higher is that 100% of short positions in both S&P 500 and Nasdaq-100 futures were recently underwater. This means that traders who bet against the market by taking short positions are facing losses. If these losses continue to grow, more traders may be forced to cover their short bets, which would require them to buy back shares, further fueling upward momentum in stock prices.

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Despite these underlying concerns, stock markets have continued their upward trend in October. However, some signs of a possible shift are emerging. For instance, on Tuesday, the S&P 500 experienced its first consecutive daily declines since early September. This marks a break in the otherwise steady march higher that the index has been enjoying. The drop, while modest, could signal that market momentum is slowing or that investors are becoming more cautious.

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The rise in Treasury yields has also been a factor weighing on the market in recent days. On Monday, a sharp rise in yields appeared to spook investors, sparking fears that the market could see a repeat of the selloff that occurred in 2023. In that instance, rising Treasury yields in August 2023 triggered a 10% decline in the S&P 500, with the market not finding a bottom until late October. On Tuesday, the yield on the 10-year Treasury note rose by 2.5 basis points, reaching 4.204%, its highest level since July.

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Higher Treasury yields can negatively impact stocks, as they often signal rising borrowing costs for companies and create competition for investors seeking safer returns. The correlation between bond yields and stock market declines is one that investors are paying close attention to, especially given the parallels to last year’s market behavior.

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In terms of market performance, Tuesday saw only minor declines across major U.S. indices. The S&P 500 fell by just 2.78 points, or less than 0.1%, closing at 5,851.20. The Dow Jones Industrial Average also edged down slightly, dropping 6.71 points, or less than 0.1%, to finish at 42,924.89. Meanwhile, the Nasdaq Composite shed 33.12 points, or 0.2%, closing at 18,573.13. While these declines are relatively small, they could indicate the beginning of a broader pullback, especially if Treasury yields continue to climb.

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In summary, while traders' bullish sentiment has driven stocks higher, Citigroup strategists are warning that such enthusiasm could lead to a market correction. With net-long positioning in S&P 500 futures at its highest level since mid-2023, concerns are growing that history could repeat itself with another selloff. Factors such as rising Treasury yields, short covering, and stretched positioning in the S&P 500 are all contributing to an uncertain market outlook. Investors will need to remain cautious, particularly as the parallels to last year’s market conditions become more evident.

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