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A Dramatic Rise in Stock Market Short Interest

(June 29, 2008)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 10 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.

4th signal entered: 50% short position on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630;

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

8th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

9th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 825.49 points as of Friday at the close.

10th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 516.49 as of Friday at the close.

As previously mentioned, we will update our readers (and “clean up” our text above) of our DJIA Timing System's performance soon after the end of this quarter, and then subsequently move to a semi-annual update schedule.  Please refer to our subscribers' area for our March 31st update.  As of Friday at the close, our DJIA Timing System is still beating our benchmark, the Dow Jones Industrials Average, on all timeframes since the inception of our system.

In their most recent best-selling book “Revolutionary Wealth,” Alvin and Heidi Toffler discussed the phenomenal growth of the PC industry during the 1980s and 1990s – including the vital roles that both Microsoft and Intel played in the process.  The Tofflers asserted that this was not due solely to the standardization and ease of use of Microsoft's software, nor was it due to the superiority and ever-rising improvement of Intel's microprocessors.  Rather, what sparked this unprecedented growth in the PC industry was the “synchronization” of both Microsoft's and Intel's product cycles (where the so-called “Wintel duopoly” provided successive products to support each other), or what the Tofflers labeled as the “Technology Ballet.”  In doing so, both Microsoft and Intel convinced that American consumers that everybody needs a PC on their desks – through the lure of more powerful machines, better software, the “coolness factor,” and so forth.  On the other hand, this “synchronization” never worked too well with the closely linked computer and communications industries, even with the advent of the internet and the World Wide Web in the mid 1990s.  Today, internet access speed remains dismal in the vast majority of areas in the world, with the exception of South Korea, Japan, and Hong Kong.

In order for an economy to sustain its long-term growth, the authors maintain that we need better institutions and infrastructure to support our economy.  One example is our educational system – a system that was designed to “churn out” workers for a mass-production-type of industrial society reminiscent of the US economy for most of the 20th century (this is a topic for another day).  In other words, in order to sustain long-term economic growth, all parts of our global economy needs to constantly “upgrade” and improve themselves – lest we start to impede overall economic growth (the U.S. highway and railroad system also stands out as a system that needs major upgrades).

Perhaps the greatest need for “synchronization” over the next five years is within our energy industry.  In fact, I would label this as the “poster child,” our political, educational, transportation, and regulatory systems notwithstanding.  As I discussed in our June 15, 2008 commentary (“The Capitalist and Productivity Engine”), years of neglect, government intervention, and the shortsightedness of global energy and energy-producing governments alike have severely inhibited Schumpeterian growth in the energy industry.  Fortunately, this is about to change, as continued technological innovations are now bringing about the confluence of alternative energy sources, including wind energy, solar power, cellulosic and sugar cane ethanol, along with improvements in the delivery of such power, such as plug-in hybrids and battery technologies.  This, I feel, is the greatest challenge to the global economy and capitalism in general over the next five years, and deserves to be in the utmost of our priorities.

Whether the U.S. stock market can resume its bull market and sustain it over the next five years will depend on the potential improvements (and commercialization) of these alternative energy technologies going forward.  Global economic growth – almost by definition – needs an ever-greater amount of energy (e.g. it costs tens of millions of dollars annually to maintain “Roadrunner,” the number one ranked supercomputer in the world at a speed of over one petaflops).  Conservation alone is not going to cut it.  Fortunately, in the meantime, there are some “stop-gap” solutions, including: 1) BP's “Thunderhorse” drilling platform, which just came online and is expected to produce 250,000 barrels/day of crude oil and 400 MMCF/day of natural gas by the end of this year, 2) The discovery and the rapid drilling of the Marcellus Formation, which is conservatively estimated to contain around 50 TCF (trillion cubic feet) of recoverable natural gas reserves, 3) The immediate availability of over 70,000 barrels/day of sugar cane based ethanol from Brazil, as long as Congress does away with its tariffs on ethanol imports, and 4) The continuing adoption of wind power and solar power, although the majority of these systems won't come online until 2009.   For now, I am optimistic that the global capitalist economies will be able to find a solution to our energy constraints – and most importantly, to bring our energy infrastructure to the “next level” – an energy infrastructure which is capable of providing a nearly limitless source of energy for global consumers going forward.  Should we fail, then get ready for some dark times, indeed.

In the meantime, as I mentioned in our last two market commentaries, I expect crude oil prices to correct over the next several months, although the structural bull market in crude oil prices remains intact.  Consequently, I also expect the stock market to at least bounce from current levels and embark on a four to eight-week rally, given the severe oversold conditions, decent valuations, very pessimistic sentiment, and the sheer amount of investable capital sitting on the sidelines.  Another factor that should give the bears pause is the dramatic increase in both the NYSE and the NASDAQ short interest over the last three to 12 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 2008:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to June 15, 2008) - For the month ending June 15, 2008, total short interest on the NYSE increased by 1.7 billion shares to a new record-high of 17.65 billion shares. The latest monthly increase is also the greatest increase on record, coming off another record increase for the month ending mid-March 2008. Given that the latest increase cannot be explained by the rise of 130/30 funds alone, my sense is that long-short hedge funds have for the most part increased their net short exposure to the equity markets - either by directly shorting stocks or by buying CDS securities (in which ase the counter-party would sell short the underlying stocks to product its downside).

As mentioned and shown on the above chart, the increase in NYSE short interest has been nothing short of dramatic over the last month, three months, six months, and even 12 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 monthly increase in short interest just hit another record high, while the six-month increase in short interest also hit a record high of 39.60%, surpassing the previous record high of 35.20% for the month ending March 15, 2008, and significantly higher than during any of the six-month periods during the 2000 to 2002 bear market.

More importantly, the latest “up crash” in short interest cannot be explained by the rise of “130/30 funds” alone.  For example, the percentage of short interest outstanding on the NYSE stood at 3.1% in mid September of last year, rising to a whooping 4.6% as of June 15, 2008.  This 1.5% increase in short interest is equivalent to approximately $210 billion in market cap (the market cap of all NYSE-traded stocks is around $14 trillion).  On the other hand, the total amount of global assets tied to 130/30 funds is estimated to only total $100 billion, with only about $40 billion coming over the last 12 months (since only 30% of these assets are used for short-selling, that means only $12 billion were used as collateral to sell short stocks).  In other words, the latest “up crash” in short selling could only be attributed to the increasing short exposure among long-short equity hedge funds, or to a lesser extent, retail investors.  One blatant example is the recent short selling done by hedge funds among financial stocks – especially during mid March as rumors swirled through Wall Street regarding the imminent demise of Lehman Brothers in light of the collapse of Bear Stearns.

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, 2008:

Nasdaq Short Interest vs. Value of NASDAQ (September 15, 1999 to June 15, 2008) - Short interest on the NASDAQ rose a dramatic 781 million shares for the latest month ending June 15, 2008 and is now at 10.45 billion shares - a record high. Moreover, the latest one-month increase is also the second highest on record - bested only by the rise in short interest for the month ending March 15, 2007. While the amount of short interest outstanding is not a good short-term timing indicator, such an increase in short interest is definitely bullish for the stock market over the longer timeframe, especially since this also confirms the record high short interest on the NYSE.

As shown in the above chart, total short interest on the NASDAQ Composite has also increased dramatically over the last six to nine months – confirming the spike in short interest on the NYSE.  While the increase in short interest hasn't necessarily been a good short-term timing indicator for the stock market, it is definitely bullish over the longer-run, as it provides “fuel” for any upcoming rally as hedge funds and retail investors alike are forced to cover their short positions.

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 July 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2006 to June 27, 2008) - For the week ending June 27, 2008, the Dow Industrials declined 496.18 points while the Dow Transports declined 284.90 points. The Dow Industrials - coming off a 1,600-point decline over the last six weeks - is now immensely oversold. At the same time, the Dow Transports has remained very resilient, as it is only 10% from its all-time high and over 17% from its January lows. Moreover, given the announced cutbacks in airline capacity over the last four weeks, and given that the bulk of the transportation group still has pricing power, I expect the Dow Transports to make another all-time high sometime in the next few months. Given the resilience of the Dow Transports, and given that it has led the broad market since October 2002, I do not expect the Dow Industrials to weaken much more from current levels. Bottom line: While the Dow Industrials is still technically weak, and while I believe the market will continue to struggle for the foreseeable future, it is unreasonable to think we are about to embark on a new cyclical bear market especially given the immense amount of investable capital on the sidelines and the overall decent valuations. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending June 27, 2008, the Dow Industrials declined 496.18 points while the Dow Transports declined 284.90 points.  While the Dow Industrials made a new low for the move (retracing its gains over the last 22 months), the Dow Transports is still holding up relatively well, as it has only declined to its mid April lows.  Moreover, it is still over 17% higher than its January lows, and 10% away from its all-time high.   In addition, given the newfound pricing power by the airlines and the continuing bottlenecks in the US transportation infrastructure, I expect the Dow Transports to resilient even if crude oil prices fail to correct over the next few weeks.  Given that the Dow Transports has been a leading indicator of the broad market since October 2002, I do not expect the Dow Industrials to weaken much more from current levels.  For now, we will remain 100% long in our DJIA Timing System – and will only seek to pare back our position if the market becomes more overbought or if our sentiment indicators become more bullish again.

Speaking of the Dow Industrials, its latest six-week decline of over 1,600 points has now made it extremely oversold.  In fact, the Dow Industrials – based on the number of components above their 200-day exponential moving averages – is now more oversold than it was during the January to March lows, as shown in the following chart (courtesy of Decisionpoint.com):

Percent of DJIA Stocks Above Their 200/50/20-EMA 3-Year - DJIA now more oversold than where it was during the January to March lows!

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 again from last week's reading of -1.9% to -4.5% for the week ending June 27, 2008.   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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending June 27, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios declined from -1.9% to -4.5% - representing the 5th weekly decline coming off the nine-week bounce from the March lows. This reading has now worked off all of its short-term overbought conditions and- with the exception of its plunge earlier this year - is now at its most oversold level since early April 2003. For now, we will remain 100% long in our DJIA Timing System - and will only reduce our position should this sentiment and other technical indicators rise to more overbought levels again sometime later this year.

With the latest decline in the four-week MA, this sentiment indicator has now worked off all of its short-term overbought conditions.  As a matter of fact, with the exception of the plunge in sentiment earlier this year, this indicator is now at its most oversold level since early April 2003.  While both the stock market and our sentiment indicators can get more oversold, I do not believe the stock market (in particular, the Dow Industrials) could decline much lower given the extremely oversold conditions, the record amount of short interest, and the immense amount of investable capital sitting on the sidelines.  For now, I am still comfortable with our 100% long in our DJIA Timing System, and will only pare back our position should the stock market or should our sentiment indicators get overbought again.

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.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - The 20 DMA of the ISE Sentiment Index has been consolildating at current levels over the last six weeks since its dramatic two-month rise off the mid March lows. More importantly, this six-week consolidation has worked off some of its short-term overbought conditions, and is sufficient to provide *fuel* for a sustainable stock market rally going forward, especially since current readings are still oversold relative to readings over the last five years. Bottom line: The 20 DMA and the 50 DMA have reversed from historically oversold levels - and are now sufficiently oversold for the market to embark on a sustainable rally.

While the ISE Sentiment Index has reversed dramatically since its mid March low, the 20 DMA of the ISE Sentiment Index has consolidated over the last six weeks and has now worked off some of its short-term overbought conditions.  More importantly, both the 20 and the 50 DMAs are still oversold relative to levels over the last five years.  Given this, the probability for much further downside is minimal, and is actually conducive to a sustainable rally over the next several months once the stock market bottoms out.

Conclusion: While the short-term outlook of the US and global equity markets still remain cloudy, there are now underlying forces at work that are conducive for a sustainable stock market rally once some of the “smoke” clears.  Aside from the immense amount of investable capital sitting on the sidelines (many private equity funds will invest in US financial institutions in a substantial way once the Federal Reserve clarifies some of the rules surrounding bank holding companies), the extremely oversold conditions, and the significant bearish sentiment, the dramatic increase in both NYSE and NASDAQ short interest over the last 3 to 12 months has also been unprecedented, and provides further “fuel” for the stock market bulls once the market reverses and long-short equity hedge funds and retail investors are forced to cover their short positions.  Aside from US equities (mainly technology and biotechnology firms), I continue to like Japanese equities, especially Japanese small caps.  In the meantime, I still do not expect a sustainable bottom in US financial institutions just yet, although we are definitely now getting very close to a capitulation bottom.  For now, we will stay with our 100% long position in our DJIA Timing System, and will only seek to pare back our long position once the stock market gets overbought again.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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