Oversold, stretched to the downside, too bearish, call it what you will, stocks bounced from another bottom this week. How long can this rally last?

 

It was the first time the Dow Jones Industrial Average fell at least 500 points and then rose 800 points in one trading day. The S&P 500 and NASDAQ gained 2.6 percent and 2.2 percent respectively. The huge turnaround was even more impressive when you consider that this week's inflation numbers, the Producer Price Index (PPI), and the Consumer Price Index (CPI) both came in hotter than expected.

 

The Bureau of Labor Statistics revealed that in September the CPI rose 8.2 percent over the prior year and 0.4 percent over the prior month. Core CPI rose 0.6 percent, month over month. Investors were hoping that inflation was at least flat-lining, but that does not seem to be the case. September's PPI came in hotter than expected, indicating a 0.4 percent jump in headline PPI. These numbers bolster the Fed's case that equity investors should prepare and accept that interest rates will be higher interest for longer.

 

However, the disappointment and subsequent sell-off that one would have expected didn't quite happen in the way day traders expected. The PPI announcement on Wednesday caused a bit of a downturn, but nothing major. Before the CPI was reported at 8:30 a.m. on Thursday, Oct. 13, the S&P 500 Index was up over 1 percent. An hour and a half later, the disappointing data had driven the market down to a new yearly low of 3,491.

 

At their lows, the NASDAQ was down 3 percent, the Dow nearly 2 percent and the S&P 500 dropped more than 2 percent. By the end of the day, however, we closed at 3,669, which was an intraday swing of 175 points off the day's low! Financial commentators were at a loss to explain the massive move up on after hitting yet another yearly low this week.

 

The explanation is simple for those who understand the options markets. Options are contracts that give the bearer the right — but not the obligation — to either buy a call or sell a put an amount of some underlying asset (in this case, stocks) at a predetermined price at or before the contract expires.

 

There were a ton of put options in place that professional investors and market makers had purchased over the last few weeks. Puts make money when the markets go down. The purpose was to hedge (protect) their stock portfolios in the event of further bad news, which is a common practice in the financial markets. They were bracing for the worst to happen and got what they wished for.

 

The CPI inflation data triggered massive selling. Billions of dollars of put options were suddenly "in the money" and traders began to take profits. What happens when you sell all these puts? The selling pressure in the markets subsides, and the markets, like a beach ball underwater, pop to the surface. Of course, Friday, we retraced more than half the prior day's gains on both the S&P 500 and the NASDAQ Indexes. That is what happened this week.

 

Technical target levels around the 3,500 level on the S&P 500 Index had been reached. It was a downside target that I, and many others, have been predicting for weeks. Markets reversed from there. Were there massive amounts of fundamental buying? No, it was simply another exercise in short covering on a grand scale. That, in a nutshell, has been behind every one of these bear market rallies this year.

 

I am expecting several more days of up-and-down consolidation before traders try to move the markets higher. I will keep my fingers crossed that this relief rally continues.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.