Short Squeezes Could Crash the Market, and Soon

Is the capital gain tax scare already over?

Stocks surged this morning, indicating that it certainly could be. Bloomberg News released a bombshell report yesterday afternoon suggesting that Presiden Biden wanted to double the capital gains tax rate, lifting it to 43.4% for wealthy Americans.

Now, upon some clarification from Bloomberg, it looks like Biden wants it to rise to 39.6%. And though that still seems high, Goldman Sachs analysts believe it will end up clocking in at a far lower rate after being presented to lawmakers.

“We expect Congress will pass a scaled back version of this tax increase,” wrote Goldman economists in a note.

“We expect Congress will settle on a more modest increase, potentially around 28%.”

Charles Schwab chief fixed-income strategist Kathy Jones sees Biden’s initial proposal coming down as well.

“I think the immediate reaction was probably a bit overdone. These proposals come out and you never know, especially with tax proposals, where we’ll end up. So it looks like an opening bid. I’m sure there will be intense lobbying from the investment community to adjust those numbers,” Jones said.

“But I think at the moment, when you have very high valuations in the market, anything that is bad news can spark a bit of a sell-off.”

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In her remarks, Jones makes an astute observation:

If the mere threat of a tax increase can send stocks spinning, what would happen in the event of another negative headline?

Gabriela Santos, JPMorgan Asset Management’s global market strategist, warned that a correction may be imminent for similar reasons.

“We’ve spent kind of the entire month of April struggling for direction in the markets. We’ve had 13 out of the 14 slowest days of the year in April. We’re just looking for new catalysts. I think the market has already priced in a lot of the surge in economic growth, in earnings growth,” Santos explained.

“And it just feels like we should consolidate, maybe even have a pullback before we continue that trend higher over 6 months and 12 months. So, I think this is just part of the market struggling to find direction in the short term.”

The next major threat could come by way of a familiar foe: activist “short-squeezers.” After spending several weeks licking their wounds, retail traders are building momentum back up for another run at hedge funds. These institutional investors – or “hedgies,” as many retail speculators call them – have loaded back up with short positions on certain stocks.

Familiar names like GameStop (NYSE: GME) and AMC Entertainment (NYSE: AMC) are among those finding their legs following over a month of selling. But activist traders are targeting new companies, too, like MicroVision (NASDAQ: MVIS) and Penn National (NASDAQ: PENN).

The last time this happened, the market almost endured a complete meltdown as hedge funds sought rapid bailouts from their peers.

If another coordinated short squeeze occurs, there could be hell to pay for bulls after the speculative peak is reached. In some ways, it would be a fitting end for the ongoing bull run. Irrational exuberance – the same reason stocks continue to climb – would deliver the rally’s “killing blow.”

All while Wall Street scrambles to rescue sinking “hedgies,” getting pulled down with them in the process.

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