Large Fund Degrossing Causing Market Divide
This split action has been going on for so long now that everyone is aware of it.
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Tuesday was another example of two-tiered market action. The Invesco QQQ Trust (QQQ), the SPDR S&P 500 ETF Trust (SPY) and the Nasdaq all hit new all-time highs, while the iShares Russell 2000 ETF (IWM) fell 0.9% and is now about 8% below its high. Breadth was better early but faded to around 47% positive by the close. There were 225 new lows to about 105 new highs.
This split action has been going on for so long now that everyone is aware of it. The cover of the October 5 edition of Barron’s read “A Market Divided: Even with the S&P 500 near record highs, many stocks are struggling.” Everywhere you look, there are statistics about how unusual it is to have such poor action in so many stocks with the indices at highs.
The good news is that Barron’s also said “We see opportunities,” and so do I. A divergence this severe will eventually correct, but will it be because the lagging stocks outperform or because the leading stocks underperform? The most likely outcome is a combination of the two, and I don’t need to know the mix in advance. The price action will tell us, and I want to be positioned in the laggards that show they are starting to catch up.
Degrossing Hits Biotech
Adding to the two-tiered action on Tuesday were some unusually large moves in the biotechnology sector. The SPDR S&P Biotech ETF (XBI) dropped 3.5%. At midday, I suspected selling of the biotech ETFs was driving the action, but degrossing by large funds looks like the larger force.
Degrossing is a reduction in exposure by large funds, and it runs in both directions. Funds sell what they own and buy back what they are short. A fund that owns $1 billion of stock and is short $1 billion of other stocks has $2 billion of gross exposure. To cut that down, it does both at the same time.
When this is done at scale, it causes some big moves, and that is what we saw on Tuesday. The covering is what squeezed recent winners Moderna (MRNA) and Twist Bioscience (TWST) higher, as funds that were short rushed to buy back shares. Once the shorts were covered, that buying disappeared and the selling took over. The stocks that had run the most fell the hardest. Ironically, the recent big winners were the stocks aggressive funds disliked the most, which is why there were so many shorts to cover.
This is mechanical trading that has nothing to do with the fundamentals of individual companies, and it is what creates the innocent victims I discussed at midday. I’ll cover degrossing and what it means for biotech in more detail on Wednesday.
Game Plan
Nothing about today changes my approach. I’m staying patient, building positions slowly, and watching for the stocks that hold up when the selling is indiscriminate. Those are the ones most likely to lead when the laggards catch up. It was unsettling to have such a big move in the biotech group, but that is what creates the opportunities.
Have a good evening. I’ll see you tomorrow.
At the time of publication, DePorre had no positions in any securities mentioned.
