What has been driving the S+P higher the past year is probably due to a few different line items. But today, I will just show one...The "short interest" on the New York Stock Exchange (NYSE).
First of all, let me explain short interest. "Going short" a stock (or bond), involves a view from the investor that the particular security in question is "overvalued". The investor can they take advantage of their view by borrowing the stock in advance from a bank/dealer/securities lender. He/she then sells the stock short...IE...they call up a dealer and, for a stock, must state to the dealer that they are "selling the stock short" (for a bond, the investor does not have to tell the dealer they are selling short).
So effectively what the short selling investor has done is, borrowed the stock and sold it short in the open market with the hopes that the stock will drop in value over the ensuing day/weeks/months (timeline determined by the investor). If the stock price does drop, then the investor can go in and buy it back at the lower price. The investor would then garner a profit between what he sold it short at and what he bought it back at (less the cost to borrow the stock including any potential dividends that he/she would have been responsible for paying while they were short). Ex - borrowing a stock from a securities lender, selling it short at $100, waiting a month, and then buying it back at $50 to net (before fees/costs) $50 profit. Sounds really easy, doesn't it?
Short-selling is typically seen as a "hedge fund" tool. At High Rock, one of the funds we managed for Scotiabank had the ability to put on short selling trades and I spent my entire 17yrs at Merrill Lynch running portfolios that were, at all times,both "long" and simultaneously "short"..(it was a huge part of what we did).
From a macro perspective, it is interesting to look at the New York Stock Exchange (NYSE) Short Interest. The theory goes that when short interest in a market (like the NYSE) is very high, it means that there might be a lot of frustrated and nervous people out there who are short and if the market doesn't sell off quickly, they are forced to "cover" (come into the market and cover or buy their shorts back because if the market keeps going higher, they will lose money by being short).
Now we will look a the chart of the S+P 500 along with the NYSE Short Interest. Here is is going back 9 years:
The bold yellow line is the S+P and the white line is the NYSE Short Interest (SI). As you can see, from about the beginning of 2013, both the S+P and the NYSE SI climbed for about 3 years and peaked in 2015. However, what happened at the end of 2015 is interesting. The S+P stopped moving higher and spent 2015 and 2016 in a volatile pattern with two big moves down and two big moves up. The NYSE SI really ramped up (that being that short sellers got very "bearish" or negative as you can see the white line moved significantly higher). But for the short sellers, stocks didn't really sell off (remember the Brexit sell off was short and the Trump sell off was so short, it didn't even make it to the next morning after the election?).
So what do you do as a short seller when you don't get satisfaction? You start to cover/buy back all of your shorts. And what effect does all this short-covering have on the overall market? Well it brings in more buyers which...drives it higher. So look as what happened in 2016-- As the NYSE SI dropped (short covering came in), the S+P rose (more buyers from short-covering).
Where does this leave us today? At High Rock, we are somewhat contrarian by nature. When we see that NYSE SI is at a 2yr low, it tells us that a massive amount of short covering has already come thru the market and leaves fewer real buyers left. This means that part of the reason the S+P popped up lately was most certainly due to short covering.
Who will buy now? Looks like short coverers are...covered.