A Dramatic Rise in Stock Market Short Interest

By: Henry To | Wed, Jul 2, 2008
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June 29, 2008

Dear Subscribers,

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.

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Henry To

Author: Henry To

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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