Amid an ongoing selloff in technology shares driven by concerns over artificial intelligence (AI) investments, UBS Securities' trading team believes the US stock market may be forming the conditions necessary for a year-end rally, with the midterm elections on November 3 potentially serving as the key catalyst to trigger such a move.
Davide Montoni, Head of Americas Institutional Equity Derivatives and Quantitative Investment Strategy Sales at UBS Securities, noted in a client report that November has historically been the strongest month for US equities, and the currently low net exposure among hedge funds could amplify a post-election market rebound.
Montoni described the current market environment as a "Combustible Setup," suggesting that if investors can navigate through the major event of the midterm elections smoothly, short covering and a renewed increase in equity exposure could jointly drive stocks higher.
Historical Seasonality and Low Positioning Combine to Form Short Squeeze Conditions
UBS data shows that since 1950, the S&P 500 has posted an average gain of 1.9% in November, making it the best-performing month of the year on a historical basis. This seasonal pattern, combined with the current positioning structure of hedge funds, creates a noteworthy combination.
Montoni pointed out that hedge funds' net equity exposure remains at low levels, meaning many institutions had previously reduced directional risk by cutting equity holdings or adding short positions. If market uncertainty declines after the elections, these institutions may increase their equity allocations again, and some short sellers could be forced to cover their positions as prices rise, thereby amplifying the rebound.
UBS's previously published seasonal research also noted that while hedge funds' net exposure is low, gross exposure remains at multi-year highs, reflecting the presence of many offsetting long and short positions in the market. This means that once market direction shifts, concentrated position adjustments could amplify price volatility.
However, UBS's assessment does not imply that the US stock market has shaken off fundamental pressures. On Monday, the Nasdaq 100 fell 1.4%, bringing its cumulative decline from its October high to over 10% and entering technical correction territory. Previously, earnings and capital expenditure plans from major technology companies such as Alphabet (GOOGL) and Amazon (AMZN) raised questions about returns on AI investments, making tech stocks the primary source of recent declines in US equities.
Montoni acknowledged that earnings reports from large cloud computing companies have not dispelled investor concerns, but believes the conclusion of the midterm elections could create conditions for a year-end short squeeze.
Election Results Remain a Variable, Financial and New Energy Sectors Face Divergence
While UBS sees potential conditions for a market rebound, different congressional election outcomes could still trigger significant sector rotation. Montoni believes that if Democrats control both chambers of Congress, financial institutions and data center-related companies could face stricter regulatory scrutiny.
The financial sector deserves particular attention. The S&P 500 financial sector had already gained approximately 6% cumulatively in October, leaving some stocks with notable gains ahead of the elections. In response to a scenario where Democrats fully control Congress, UBS recommended buying put options on the Financial Select Sector SPDR Fund (XLF) expiring November 20 to hedge against potential short-term pullback risks in the financial sector.
Meanwhile, UBS believes new energy stocks could see a different market reaction. Investor positioning in renewable energy stocks has currently dropped to its lowest level in about a year. If election results reinforce market expectations for continuation or adjustment of new energy policies, renewed capital inflows into related sector exposure could drive share prices higher.
According to UBS observations, traders last week bought call options on the Invesco Solar ETF (TAN) expiring in December, indicating that some investors are positioning ahead of related scenarios through derivatives. This also means that even if the broader market rebounds after the elections, performance across different sectors could still vary significantly.
Whether the Rebound Can Be Sustained Still Depends on AI and Macro Risks
Beyond UBS, some Wall Street institutions are also watching for a potential recovery in market risk appetite after the midterm elections conclude. Investors generally hope to quickly digest the political uncertainty brought by the elections. According to ORATS data, the options market at the time expected the S&P 500 to move approximately 0.8% on the day after the elections, slightly above the 0.6% average implied daily move over the past month.
However, Wolfe Research strategist Chris Senyek believes that while the market may benefit from the dissipation of election uncertainty, concerns over AI investment returns could still cap gains. He noted that investors' focus on major technology companies has shifted from the scale of capital expenditure to actual profitability, and companies need to demonstrate through earnings that massive AI investments are justified.
Additionally, the situation in the Middle East remains a significant macro uncertainty. If the United States re-escalates military action against Iran after the midterm elections, oil prices and inflation expectations could come under pressure once again.
Therefore, the "Combustible Setup" described by UBS reflects more of a potential short-term price reaction driven by market positioning and seasonal factors, rather than a judgment that corporate earnings prospects have already improved. For US stocks in the coming weeks, whether election results can be smoothly digested, whether hedge funds will concentrate on covering shorts, and whether AI-related companies can stabilize market confidence will collectively determine the strength and sustainability of any potential rebound.
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