High Short Interest the Achilles' Heel of Bears
(July 1, 2007)
Dear Subscribers and Readers,
Before we begin our commentary, I want to first mention a few things. First of all, there will be no regular commentary next weekend, as my partner, Rex Hui, is coming into Los Angeles on Thursday from Hong Kong and we will take the opportunity to catch up and discuss our business and investment strategy, etc., going forward. Instead, I have asked David Korn of Begininvesting.com to write a guest commentary for us. David has graciously agreed to do it – I will let you know what topic he will be writing about in our upcoming mid-week guest commentary.
Another development that I want to mention is that there are now signs of stress creeping up in the CMBS sector, in addition to the troubles that we have been witnessing in both the CDO and the CLO market. Moreover, within the subprime mortgage market, we are also now witnessing significant losses in the 2005 vintage as well, as opposed to only the riskier 2006 vintage. The years of excesses are now starting to come home to roost.
Finally, for readers who are keen on technology, you may have noticed that the semi-annual list of the world's 500 fastest computers was published last week at the International Supercomputing Conference in Dresden, Germany. In last weekend's commentary (“The Times They Are a-Changin”), I discussed the profound changes that technology would continue to have in both our economy and society over the next 10 to 15 years – with a special emphasis on computing power, ever-increasing bandwidth (e.g. the bandwidth consumed by the website, Youtube, is now greater than all the bandwidth that was required to run the internet in 2000), genome sequencing and other medical technology advances, and the commercialization of solar power and other alternative energy sources. In that commentary, I mentioned that an entire automobile could be designed virtually on a 10-petaflop supercomputer without building any physical models (incidentally, there was a whole day of talks and seminars at the conference dedicated to supercomputing in the automotive industry). Based on both IBM and the Japanese government's supercomputing timelines, a fully functional 10-petaflop computer should be available by the second half of 2009. This is especially amazing when you consider that the sum of all the supercomputers on the June 2007 Top 500 list only totals 4.92 petaflops! Times definitely “are a changin.”
Now, following is an update on our three most recent signals in our DJIA Timing System
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
As of Sunday evening on July 1st, we are neutral in our DJIA Timing System (subscribers who want to go back and review our historical signals can do so at the following link). While it would have worked out well if we had continue to hold our long position since May 8th, we decided to exit our position at that time since there were many signs – including most of our valuation, sentiment, and liquidity indicators – that the rally was getting tired. We continue to stand by this position. However, we currently do not plan to go short in our DJIA Timing System – not even in the midst of the latest Bear Stearns hedge fund crisis – at least not until we see a brief but weak rally in the stock market. We also would prefer to see a Dow Industrials reading in the 13,800 to 14,200 area before shorting, but this point, we cannot be “greedy,” so this author may actually end up on initiating a 50% short position in our DJIA Timing System should we see an unsuccessful retest of the previous all-time high, assuming that the rest of the market (and the Dow Transports) remains weak. Should we decide to go short, we will inform our subscribers by emailing you a real-time “special alert.” While equities still remain relatively cheap (as measured via valuations since 1994), readers should keep in mind that on a relative basis (especially in relation to U.S. bonds), U.S equities are still near its most expensive level since May 2006, despite the weakness of the stock market over the last few weeks. Combined with the liquidity headwinds that we have previously discussed, stocks are definitely not too attractive at this point, especially as the Yen carry trade is now very stretched by any measure and as the world's major central banks are still in a tightening phase. Because of these reasons, we have chosen to get out of our 100% long position in our DJIA Timing System on May 8th.
Now, let us continue.
In last weekend's commentary, I discussed the further deterioration of the liquidity situation within the global financial markets by starting off with a rundown of the ever-increasing subprime problem, in light of the collapse of the Bear Stearns hedge funds that invested primarily in the CDO market. As everyone and his/her neighbors should know by now, the fact that Bear Stearns arranged a bailout as opposed to liquidating both of its funds is evidence that there is no market for many of these instruments in the open market, and that any bids for many of these instruments could be as low as 30 cents on the dollar. I then continued: “Essentially, this has now turned into a game of musical chairs – but with no chairs. To further compound the problem, the majority of central banks in the world today is still in the midst of tightening – and even at this point, the Federal Reserve has gone on record and stated that it is concerned about inflationary pressures more than anything else, despite the fact that it is also keeping a close eye on the Bear Stearns situation. Finally, given Merrill's response to Bear's bailout plan last week, it is also evident that many Wall Street banks is now significantly pulling back from crediting liquidity within the financial markets and from taking on significant risks. This is exemplified by the fact that many Wall Street banks are now hiring bankers and lawyers that specialize in buying or dealing with distressed debt. In other words, the vultures are already circling above their preys – and my guess is that Wall Street is now significantly pulling back because they don't want to become preys themselves.”
For those who believe that the stock market has already discounted the subprime troubles (after all, the stock market is usually a very effective discounting machine), I also quickly discussed that as a group, it is human nature to not react until someone else has. There were two major reasons for it: 1) human beings tend to extrapolate the recent past into the indefinite future, and 2) human beings don't usually want to stand out from the crowd, and preferring to follow and only opine on a view until someone else. Given that the market had been relentlessly rising since the mid June 2006 bottom, and given that it also quickly shrugged off the subprime troubles during late February to mid March, there is good reason to believe that many investors are ignoring clear road signs that liquidity is declining drastically – and that, at some point, it is going to have a significant impact on stock prices. A good example is the “capitulation” of many popular formerly bearish market commentators to the bull side – commentators which for the most part had been bearish since the current bull market began in October 2002 (again, I am not going to mention any names).
From there, we continued on with our “usual discussion” on the Yen carry trade. Even though the Yen carry trade is now very overstretched by any measure, I concluded that: “In the meantime, we probably haven't seen the bottom in the Japanese Yen just yet – as Japanese retail investors are now preparing to invest their semi-annual bonuses out of Japan en masse over the next few weeks. Furthermore, given the light volume surrounding the July 4th holidays, there is no telling what the market may do.” Given the light volume in the markets this week, and given that Japanese retail investor money has most probably not been fully invested into the global market just yet, I would definitely hold off on going long the Yen (vs. the dollar, Euro, Pound, AUD, CAD, etc.), for now. Once volume starts returning in the middle of next week, however, there then will be a good chance of seeing some upside in the Yen – and by definition, a further decline and potentially stranglehold on global liquidity.
Besides the Yen carry trade, the Swiss carry trade is now getting its fair share of print, as we have discussed in our discussion forum over the last few weeks. Moreover, the Swiss Franc carry trade is now estimated to be over $650 billion large – with most of the “carry traders” located in Eastern Europe. As a matter of fact, many of these “carry traders” are households and small businesses who have taken out mortgages or loans denominated in Swiss Francs. The following graphic from the Wall Street Journal is a good summary of the carry trade position in four major Eastern/Central European countries:
An important note: The above chart utilized figures as of June 2006, and is therefore severely outdated. At last glance, 80% of all mortgages being originated in Hungary is now denominated in a foreign currency (most likely the Swiss Franc or the Japanese Yen) – and we're now seeing similar numbers in Bulgaria, Romania, and Poland. Moreover – just like the Japanese Yen – the Swiss Franc is not a “natural carry trade” currency, as Switzerland enjoys the largest current account surplus out of all developed countries at 17.7% of GDP, as well as a net $500 billion position in foreign assets. Finally, given that the Swiss central bank has hiked its borrowing rates from 0.75% to 2.5% over the last two years – with analysts projecting a 3.0% borrowing rate by the end of this year – there is no doubt that the Swiss Franc carry trade is now showing signs of stress. Given that Hungary is also running a current account deficit equal to 5.2% of its GDP, and there is a good reason to believe that the first emerging market country to fall in any upcoming global liquidity crisis could very well be Hungary, with other candidates such as Poland and Iran quickly following soon afterwards.
To top it all off, we are also now witnessing signs of stress in the CLO (which is actually a subset of the CDO market, but backed by loans instead of mortgages), as well as in the CMBS market, as U.S. commercial real estate starts to cool (see our February 1, 2007 commentary, “REIT Market Overheating?”). Sam Zell (he decided to sell Equity Office Properties Trust to Blackstone in a $23 billion buyout offer earlier this year) really had good timing skills, after all. Not to mention the fact that the so-called “Skyscraper Index” had most probably once again called the top of the real estate market, with the recent announcement of the 2,000 feet tall Chicago Spire (the other notable times when this index called the top of the real estate market was the construction of the Empire State Building in 1929 and the construction of the Sears Tower in 1969). As Carol Willis, the founder of the Skyscraper Museum's, stated in a recent article: "If you look at any economic cycle of construction, back through the 20th century, buildings always appear in cycles," she said, "and the tallest usually appear before a crash."
Just like everything else that may look “perfect” on the surface, however, there is always an Achilles' heel. In the case of the liquidity-induced correction that I have been looking for over the next three to six months, the culprit is the tremendous increase in both the NYSE and the NASDAQ short interest over the last four months. For illustrative purposes, let us first look at the following monthly chart showing the total amount of short interest outstanding on the NYSE vs. the Dow Industrials from November 2000 to June 2007:
As mentioned and shown on the above chart, the increase in NYSE short interest has been nothing short of dramatic over the last few months – an increase which could only be matched by the increase in short interest during the 2000 to 2002 bear market. As a matter of fact, the latest 12-month increase in short interest just hit a record high of 37.2%!
This increase in short interest on the NYSE is also being confirmed by the increase and outstanding short interest on the NASDAQ Composite. Following is a monthly chart showing total short interest on the NASDAQ vs. the value of the NASDAQ Composite from September 15, 1999 to June 15, 2007:
As stated before, the Achilles' Heel for the bearish scenario over the next few months is the abnormally high amount of short interest on both the NYSE and the NASDAQ Composite. Should the market fail to start correcting soon, then many short-sellers could start losing patience with their short positions and start covering – thus causing a tremendous short-covering rally.
That being said, a small but significant chunk of the short interest statistics nowadays is now held by mutual funds that engage in 130/30 strategies (here is a good Goldman Sachs primer on 130/30 strategies). While the total amount of pension or other institutional assets in this type of funds are unclear, estimates have them now ranging at $60 to $100 billion, with a further 100% increase in projected asset inflows over the next 12 to 18 months. Interestingly, however, this does not explain the majority of the increase in short interest (keep in mind that we need to take 30% of whatever new inflows these funds experienced over the last three to four months, which is probably, at most, $8 billion or so) – as on the NYSE alone, a back-of-the envelope calculation suggests that the total increase in short interest over the last four months has a dollar value of over $100 billion. The continued proliferation of hedge funds and in general, long-short equity/market neutral mutual funds could be another explanation as well – but it is interesting to note that the explosion of short interest was only a recent phenomenon – even though short interest has been steadily increasing since early 2004. A final reason could be the huge buyout activity over the last few months – giving a great number of hedge funds the opportunity to engage in merger arbitrage. Most likely, it is a combination of all these reasons – in addition to just old-fashioned bearishness. While the “staying power” of hedge funds and 130/30 mutual funds is definitely much stronger than the staying power of most investors, I urge you to be vigilant anyway if you are shorting, even as our liquidity and breadth indicators continue to deteriorate.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2005 to the present:
For the week ending June 29, 2007, the Dow Industrials rose slightly by 48.36 points while the Dow Transports declined 9.34 points, failing to confirm the Dow Industrials on the upside. More ominously, the Dow Transports has been exhibiting such weakness for the last few months – with the latest Friday close representing the lowest weekly close by the Dow Transports since April 13th, and approximately 4.5% from its all-time closing high. Moreover, this latest decline is also being confirmed in a big way by the Dow Utilities, as the Dow Utilities index – even though it was up last week – is now 7% below its all-time high of 535.72 made on May 21st. For now, we will continue to maintain our completely neutral position in our DJIA Timing System and will probably initiate a 50% short position in our DJIA Timing System should the Dow Industrials retest its all-time high, and should this all-time high be accompanied by continued weakness in breadth (and a non-confirmation by the Dow Transports), along with a Barnes Index reading of over 70 (it is currently at 64.00, declining from 64.40 during the week). Should we decide to go short, we will inform our subscribers by via a real-time “special alert” through email.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators decreased slightly from last week's 23.5% to 23.3% for the week ending June 29, 2007 – a sign that the market is not overly bearish and that there should be more downside to come. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
While the latest reading of 23.3% is definitely not at an overbought level, readers should keep in mind that it is nowhere near oversold either. Given that this reading also did not get very oversold during the late February to mid March decline, this author is thus very hesitant to buy stocks again until this reading has gotten to a more oversold level, such as what we experienced during the April 2005 (8.5%), the October 2005 (11.6%), and the June 2006 (1.7%) bottoms. For now, we will remain neutral in our DJIA Timing System, but should we witness some kind of spike (in the 3% to 5% range) over the next couple of weeks in this indicator, and should this be accompanied by a retest of its all-time highs by the DJIA, and a Barnes Index reading of over 70, then we will probably initiate a short position in our DJIA Timing System.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:
While the 20-day moving average of the ISE Sentiment (at a current reading of 132.8) is still not close to overbought levels, its rally from a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) to 137.8 as of June 4th was definitely getting long in the tooth – and as such, a correction is definitely overdue. Even though the 20-day MA has since stagnated and is now at a reading of 132.8, this reading is still somewhat elevated – and therefore, my best guess is that the market will continue to struggle throughout this summer. More ominously, the 20-day MA of the ISE Sentiment has declined below its 50-day MA (after a false signal on June 12th), and has stayed below its 50-day MA for over a week, suggesting that the ISE Sentiment Index is now in a downtrend. However, should this experience some kind of spike in the coming days, and should this be accompanied by a rest of its all-time highs by the DJIA, and a Barnes Index reading of over 70, then we will most likely initiate a short position in our DJIA Timing System. The bottom line is that unless the 20 DMA gets more oversold again, we will continue to avoid a long position our DJIA Timing System.
Conclusion: While subscribers may be getting tired of this message by now, the evidence continues to pile up warning of an imminent liquidity crunch sometime over the next six months – as exemplified by the continued troubles in the CDO market, as well as new signs of stress in both the CLO and now the CMBS market as well. Given the continued reluctance of the Federal Reserve to cut rates (I personally do not expect a cut unless the stock market experiences at least a 10% correction from its 2007 highs), and given that the Bank of England, the European Central Bank, the People's Bank of China, and even the Bank of Japan are still on a “war footing,” there is no doubt that liquidity will continue to remain tight at least for the next few months. While many investors can still find solace within both the Japanese and the Swiss currencies, folks should understand that the Swiss Central Bank has also been on a tightening cycle – raising its overnight rate from 0.75% to 2.5% over the last two years – with rates expected to rise to 3% by the end of this year. Moreover, there is no doubt that both the Yen and the Swiss Franc carry trade is now overstretched on many levels – all it now takes is another “liquidity event” such as what we experienced during late February to early March, and the rest will be history (in such a scenario, the most likely countries to fall will be the ones in Eastern Europe, as opposed to East Asian countries during the 1997 Asian Crisis).
However – even though both our liquidity and breadth indicators continue to deteriorate – folks who are bearish here should be very vigilant when it comes to shorting individual stocks, given the record-breaking jump in short interest over the last three to four months. While there are valid explanations for this jump (valid explanations that won't add much fuel for the bull's case), the sheer increase in short interest is nothing to sneeze at – and we will not know for sure just who or which entities were responsible for this jump until it is too late. I urge you to please stay tuned, as always.
Henry To, CFA