A short-covering rally has stocks on shaky footing. Here's what could happen next.

By Joseph Adinolfi

Investors point to signs that short covering and position shuffling have driven much of the rally over the past two weeks - but different types of investors have plenty of capacity to keep buying

U.S. stocks have staged a blistering rebound, but who exactly has been doing the buying?

U.S. stocks have staged a big rebound over the past two weeks following what was, by some measures, the worst stretch for the market since last April's tariff tumult.

But before the bulls get too excited, some strategists have spotted signs that the selling might pick up again soon. The rally has been strong - with the Dow Jones Industrial Average DJIA capturing its best two-week point gain since 2022 - but data on trading volumes suggest it might be built on shifting sands.

Arms Index

The New York Stock Exchange Arms Index has seen its five-day moving average spike to 1.39 this week, the highest level since early 2024, according to FactSet data.

When the Arms Index rises during a rally, it generally doesn't inspire confidence that gains are being built on solid footing, said Ben Kizemchuk, a senior investment adviser and portfolio manager at Wellington-Altus in Toronto. A rising Arms Index suggests more volume is flowing into declining stocks than rising stocks.

Kizemchuk sees the Arms Index as an indicator of whether a rally is being supported by "real buying" or by short-term flows like short covering. Given how positioning in the market has trended over the past month, Kizemchuk sees recent moves as not terribly promising.

"Selling pressure is persisting beneath higher index prices, meaning the advance is being driven by a narrow group of stocks, or that it's short covering rather than broad demand," Kizemchuk told MarketWatch in response to a question via email.

To cover a short, an individual investor or trading firm needs to buy back shares of a stock they had sold short - meaning they borrowed the shares, then sold them, hoping to profit if the price should fall.

Kizemchuk sees this as one reason investors should remain cautious and resist the temptation to chase the market higher. He pointed out that the Arms Index flashed a similar pattern several times as stocks made their way to their pre-financial-crisis record highs in late 2007.

And to be fair, even investors who have taken a more optimistic tack have acknowledged that tactical buying by hedge funds and other sophisticated investors appears to be doing much of the heavy lifting here. Data from Vanda Research and others have shown that retail buying has been subdued lately, robbing the market of what had become a critical source of demand for stocks.

Relative strength

This past week, Jefferies trader Michael Toomey shared more than a dozen indicators he has been monitoring lately to try to get a sense of where the market might be heading next. He pointed to some signs that stocks may have risen too far, too fast.

See: Has the cease-fire rally pushed stocks too high, too quickly?

For example, the S&P 500's relative strength index, or RSI, has, over the past week, tallied its biggest six-day jump on record - rising more than 30 points.

Large swings in the popular momentum gauge could indicate that the market is vulnerable to a reversal after moving too far, too quickly.

"If you're looking for a reason not to chase, this chart is for you," Toomey said about the chart above in commentary shared via email.

But Toomey also sees plenty of reasons to expect that stocks can continue to run higher, although this could ultimately depend on how eager investors are to take advantage of more attractive valuations.

After this week's rebound, the S&P 500's forward price-to-earnings ratio stood at around 20, below its high above 23 from late last year, FactSet data showed. Also, the futures curve tied to the Cboe Volatility Index VIX is no longer inverted, suggesting the market may have bottomed. The index itself finished Friday below 20, according to FactSet.

See: Wall Street's fear gauge just flashed an unusual signal that could carry the S&P 500 to 7,400 within months

CTAs buying

Another promising sign: Analysts at Goldman Sachs expect commodity trading advisors - systematic, trend-following hedge funds that typically play in the futures market - will be net buyers of stocks in practically every scenario next week. In a flat tape, CTAs could buy $45 billion worth of stocks, according to a Thursday reading from Goldman's model. That is one of the highest readings in the history of the model, and nearly equivalent to how much these funds are estimated to have sold over the past month.

Regardless of what happens next, it would be hard to argue that the rally was driven solely by positioning. Investors clearly embraced a tentative cease-fire earlier this week, and they likely remain laser-focused on developments in Iran, said Ed Mills, a Washington policy analyst at Raymond James.

That truce remains fragile, leaving a major risk hanging over markets. Mills said he thinks the most likely outcome from weekend negotiations between the U.S. and Iran will be a pledge to cease hostilities in exchange for the Iranians reopening the Strait of Hormuz to more tanker traffic. A discussion of Iranian nuclear enrichment will likely be left to a later date.

Still, there could be other unresolved issues that investors may need to contend with over the coming weeks. Few energy analysts expect crude-oil prices to retreat back to their preconflict levels this year. And there is always the possibility that hostilities might reignite.

"The cease-fire - conditional on the Strait of Hormuz being reopened - was a clear relative positive, but new questions have arisen: 1) the extent to which it is actually in effect (especially with regard to the Strait of Hormuz), and 2) whether it will it hold," Mills said in written commentary.

U.S. stocks tallied a second straight week in the green, even as jitters surrounding this weekend's peace talks in Islamabad between the U.S. and Iran caused the S&P 500 SPX to finish Friday in the red. The S&P 500 still gained 3.6% on the week, while the Nasdaq composite COMP rose 4.7% and the Dow advanced 3%. All three logged their best week of gains since Nov. 28.

Tomi Kilgore contributed.

-Joseph Adinolfi

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04-11-26 0800ET