NYSE Short Interest Again at All-Time High

By: Henry To | Tue, Aug 23, 2005
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Dear Subscribers and Readers,

We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. As of Friday at the close, the Dow Industrials stood at 10,559.23 - giving us a slight gain of approximately 56 points. The market should remain relatively quiet this week - both the IPO calendar and volume transactions will not pick up again until after the Labor Day Weekend. For now, the key indicators to watch are still the Bank Index, energy prices, and the housing market. No new signals are expected this week - for now, the market is mired in a ST downtrend and this author is expecting this downtrend to continue, despite the fact that many commentators is calling for the beginning of a bull trend sometime this week. More details to come in the following paragraphs.

Dear readers, please continue to give us feedback on our commentaries and discussion forum so that we can better understand how to serve all of you going forward. Again, we will be shifting to a subscription model as of October 1st. However, we will also be offering a free 30-day trial subscription for all first-time subscribers (which does not include our current subscribers in our mailing list) and a discounted $39 six-month subscription for the first six months (i.e. between November 1, 2005 and May 1, 2006). From May 1, 2006 and onwards, an annual subscription to our commentaries will be $99 per year (with appropriate adjustments for a monthly or a six-month subscription).

Here is a thought for this week: Following is a quote from Dr. Stephen Covey's new book, "The 8th Habit": "When asked specifically what is truly unique about this book that adds value to the leadership material on the market, Covey responds, "I would say five things: First - the sequential development. I know no book that focuses on the absolute necessity of personal development and integration before trust can be built at the relationship level."

This author believes the idea and the necessity of "sequential development" is broader (and deeper) than that. Think about it - the United States of America has always been one of the world's most capitalistic countries. A significant number of foreign citizens who have not set foot in this country believe that the roads here are "paved with gold" and that getting wealthy in this country is really easy. In a way, that is true - but just like any other significant endeavor or milestone in life, it is really not as easy as figures like Mr. Robert Kiyosaki (of "Rich Dad, Poor Dad" fame) claim to be. For example, as savvy investors and traders, I bet that many of our subscribers have had at least one experience where a family member or co-worker had asked for stock tips (perhaps more often in the late 1990s than now) - thinking they can make money even though they do not plan to spend much time or effort in learning about the stock market or individual stocks. Obviously, that is not the case - as many of our subscribers can attest to. I believe the idea of sequential development is an absolute necessity - not only in making money in the financial markets but in having the ability to keep your gains as well. Remember, the financial markets is most probably the most competitive arena in the world today. The process is as important (if not more important) than the results. But then, I guess most of our subscribers know that already.

Let's now get on with our commentary. There are two things that I want to first discuss. First of all, the September NYMEX contract for crude oil is over $65 a barrel as I am typing this. Sure, the Market Vane's Bullish sentiment for crude oil is high - but both the 21-day and the 55-day moving average of the Market Vane's Bullish Sentiment are not as overbought as what they were during the three significant peak in oil prices in 2004 - shown in the following daily chart depicting the WTI Crude Oil Spot Price vs. the Market Vane's Bullish Sentiment (which has been updated from last week)

WTI Crude Oil Spot Prices vs. Bullish Sentiment (January 2003 to Present) - 1) The three most recent spikes of oil prices in 2004 were accompanied by bullish sentiment that were even more bullish than the current sentiment - despite current oil prices in the 60s. 2) Interestingly, the current rally in oil prices (at approx. $65 a barrel), is still not accompanied by a higher high in bullish sentiment - suggesting that there is still upside potential for oil prices...

The message of the above chart remains the same as last week - that crude oil prices can still go higher despite current extreme bullish sentiment in the Market Vane's Bullish Consensus. Moreover, one thing that caught my eye over the weekend was the sheer number of analysts and commentators already calling for a top in crude oil prices. Given the current situation in Ecuador and given that the worst part of hurricane season is only just beginning, one cannot be so sure at this point. While our MarketThoughts.com Global Diffusion Index is definitely calling for lower oil prices within the next three to six months, I would not touch crude oil with a ten-foot pole here. The fact of the matter is: No popular article that I have read so far this weekend is calling for higher crude oil prices. Because of this, the final ascent to the top may be more ferocious than any of us here could expect.

The second thing I want to discuss is this: Many of the same analysts and commentators are calling for higher equity prices ahead - despite the fact that many of the major market indices (including the Bank Index and the S&P homebuilding index) are still mired in at least ST downtrends. The most recent action of the NYSE McClellan Oscillator and Summation Index just says it all (following chart is courtesy of Decisionpoint.com):

NYSE McClellan Oscillator and Summation Index - The McClellan Oscillator has been in negative territory since early August and has shown no signs of moving back to positive territory& Meanwhile, the Summation Index is nowhere near oversold territory and is still trending down...

Both the NYSE McClellan Oscillator and the Summation Index (which is basically a running count of the McClellan Oscillator) are breadth indicators - suggesting that the trend of most of the stocks that are traded on the NYSE exchange is down. The action of the NASDAQ McClellan Oscillator and the corresponding Summation Index is very similar. The fact that not many analysts or commentators are acknowledging the current downtrend combined with the lack of an oversold condition suggests the current downtrend in many of the major market indices should continue - at least until Labor Day Weekend. This will most probably also correspond with a period of still higher crude oil prices. Readers please stay tuned.

In Thursday's commentary, we discussed the fact that liquidity was waning - as evident by the relative underperformance of the Philadelphia Bank Index, declining M-3 growth, and declining cash levels in both cash and margin accounts of investors. Combined with the current downtrend and the lack of an oversold condition, and you have a great recipe for a continuation of the current correction in the market. However - as evident by the subject of our commentary - there is some longer-term encouragement for the bulls, as the total amount of short interest on the NYSE just recently rose to an all-time for the month ending August 15, 2005. The total amount of shares that are shorted on the NYSE is now at 8.59 billion shares - 27 million shares more than the prior record set on May 15, 2005 and only 381 million shares more than the short interest outstanding on October 15, 2002 - right at the bottom of the last cyclical bear market. In a bull market, a higher short interest generally provides "fuel" for the bulls, as the general uptrend in prices tend to force speculators to cover their short positions - thus strengthening the existing uptrend. Following is a monthly chart showing the short interest outstanding on the NYSE vs. the Dow Industrials from November 15, 2000 to August 15, 2000:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to August 15, 2005) - For the month ending August 15, 2005, total short interest on the NYSE increased 228 million shares, after dipping 212 million shares during the June and July period. Total short interest on the NYSE is now at an all-time high of 8.59 billion shares, breaking the previous all-time high just set on May 15, 2005.  However, this all-time high does not signal an imminent rally, as the three-month increase in short interest is only 1.73% - substantially lower than the record of 10.79% set on May 15, 2005.

While the amount of short interest on the NYSE is now at an all-time high, it does not necessarily imply immediately higher prices up ahead. In fact, the three-month increase in short interest is only 1.73% - substantially lower than the 10.79% increase in short interest for the three months ending May 15, 2005. My guess is that unless there is a huge jump in short interest during the next few weeks, the market will still be mired in a downtrend. Over the longer-run, however, an ever-increasing short interest is definitely good for the bulls.

To put this into clearer perspective, one should take a look at the NYSE Short Interest Ratio, which is basically the total amount of short interest outstanding on the NYSE divided by average daily volume. Recent bottoms (October 2002 and October 2004) have ended with the NYSE SI ratio at 6.7. During June of this year, the SI ratio spiked to a relatively high level of 6.2 - but in retrospect, this relatively bullish development was still not enough to usher in a ST bottom for the stock market. While the total outstanding short interest on the NYSE is at an all-time high, the SI ratio is still "only" at 6.0 - suggesting that short interest may not be quite high enough to signal at least a ST bottom in the stock market. Following is a monthly chart showing the NYSE Short Interest Ratio vs. the Dow Industrials from January 1994 to the present:

NYSE Short Interest Ratio vs. Dow Industrials (January 1994 to Present) - Note that the SI ratio during October of last year spiked to a level not seen since the October 2002 level - giving us a decent rally during the November to December 2004 timeframe.  Please also note the most recent spike to 6.2 in June and now 6.0 in August - is this enough to give us a bull rally?  My guess: Probably not although it is a positive long-term development for the bulls.

As I have mentioned earlier, the recent increase in short interest is a longer-term bullish development, but for now, it is still not high enough (and it has not spiked high enough in the last three months) to signal an impending stock market bottom. If I have to guess, I would most probably not put any money on the long side until the SI ratio spikes again to the 6.7 level - which would mean (at least) a further 10% increase in the total amount of short interest outstanding on the NYSE in the next few months.

Let's now take a look at the most recent action - starting with the following daily chart of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to August 19, 2005) - 1) The Dow Transports failed to confirm on the downside - which ultimately carried bullish implications for the Dow Industrials! 2) For the week, the Dow Industrials and the Dow Transports declined 41, and 29 points, respectively.  Despite the fact that these two popular Dow Indices are still mired in ST downtrends, many analysts are still calling for higher prices ahead - which is bearish in itself. While the fact that the Dow Transports has held up so well despite >$60 a barrel oil prices is encouraging, the cynical side of me is thinking that investors are being too optimistic - suggesting either even high oil prices ahead or a lower print in the Dow Transports in due time. At this point, I am still relatively comfortable with our 25% short position in our DJIA Timing System - especially in light of ever-rising oil prices and a continuing clampdown on liquidity by the Federal Reserve and most Central Banks around the world.

For the week ending August 19, the Dow Industrials and the Dow Transports declined 41 and 29 points, respectively. The resiliency of the Dow Transports through record oil prices is nothing short of amazing. In a way, this signals the underlying strength in the economy, as most fuel costs (aside from the airlines') of the transportation companies have been passed through to their customers. However, it is interesting to note that the Dow Industrials have been severely lagging over the last 20 months, and that the previous high in the Dow Industrials during early March of this year was still 800 points away from its all-time high made back in January 2000. For now, the Dow Transports is still giving us relatively bullish signals, but please note (not shown on this chart) that the Dow Industrials is sitting right at both its 50-day and 200-day moving averages. Should the Dow Industrials experience a significant decline in the coming week, then it would have convincingly broken these natural support levels.

Let's now take a look at our most popular sentiment charts - starting with the Bulls-Bears% Differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey again AGAIN took a plunge from 11% to negative 11% in the latest week.  I would now interpret this as bearish since the market is now at least in a ST downtrend - along with the fact that the most dramatic declines in the stock market have occured in the face of an oversold reading in the AAII survey.  The March to April 2005 period was a prime example, as the AAII bulls-bears% differential initially declined to negative territory during mid-March.  The subsequent decline in the market was to last another four weeks.  For now, we will stay 25% short in our DJIA Timing System.

The AAII survey continues its volatile ways - with the bulls-bears% differential declining a full 22 percentage points during the latest week, and a huge 51 percentage points during the last three weeks! While this has sometimes meant at least a ST bottom, readers should also note that the most severe declines have occurred while the AAII survey is in oversold territory. More importantly, the oversold condition in this survey is not being confirmed by readings from either the Investors Intelligence Survey or the Market Vane's Bullish Consensus - suggesting that the market should still have some more downside to go.

As I mentioned above, the Bulls-Bears% Differential in the Investors Intelligence Survey is not confirming the oversold condition in the AAII survey. For the week, the Bulls-Bears% differential in the Investors Intelligence Survey declined from a highly overbought 39.8% reading to a milder 34.8% - but still overbought nonetheless:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey declined back to its level from two weeks ago - declining from a reading of 39.8% to 34.8%.  My guess is that this survey will confirm the oversold condition of the AAII survey in due time - suggesting lower prices within the next few weeks.  Again, combined with the 'reassurance' of further hikes in the Fed Funds rate and given ever-rising oil prices, I would say that we are pretty comfortable with our 25% short position in the DJIA Timing System.

My guess is that this reading will continue to decline until it gets to oversold territory - thus signaling lower prices ahead. For now, we will stay 25% short in our DJIA Timing System.

Readers should keep in mind that the Market Vane's Bullish Consensus has been the most "correct" sentiment indicator out of our three sentiment indicators since January 2004 - in that the Market Vane's Bullish Consensus never really got too oversold during the March 2004, May 2004, August 2004, October 2004, and April 2005 ST bottoms - thus signaling relatively weak rallies ahead. This has definitely proven true - contrary to the very oversold readings that we were getting from both the AAII and the Investors Intelligence Surveys during most of those ST bottoms. So what is the Market Vane's Bullish Consensus signaling now? Look no further than the chart below:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus inched down from 65% to 64% in the latest week - thus further (and convincingly) breaking the streak of 11 consecutive weeks of over 65% readings.  The ten-week moving average of this reading declined slightly from 68.1% to 67.7% - suggesting that bullish sentiment should have turned here.  My guess is that it has, and thus would be a red flag for the bulls, given that the Market Vane's Bullish Consensus is reversing from such an overbought level as well.

After an 11-week consecutive string of 65%+ readings, the Market Vane's Bullish Consensus finally declined to 65% a couple of weeks ago - and it's now at 64%. The fact that the Market Vane's Bullish Consensus is reversing from such an overbought condition suggests that the environment should get pretty difficult for the bulls in the coming weeks. Again, I am still relatively comfortable with our 25% short position in our DJIA Timing System at this stage.

Conclusion: While the record-high short interest should be bullish indicator in the longer-term - I am still relatively skeptical of the short to intermediate timeframe for the stock market as both the short interest and the short interest ratio has not spiked high enough to signal any impending bottom or reversal. Moreover, it is not obvious to me that crude oil prices have topped. Even though the Market Vane's Bullish Consensus for crude oil is very overbought, it is still not as extremely overbought as it was during the three peaks in 2004. Moreover, many prominent analysts and market watchers have already brushed aside the possibility that crude oil prices can still go higher, and since tops are inherently difficult to call, I would not even try to go there (I have done that to my dismay many times in my career). The Iraqi stoppage of oil exports (1.5 million barrels a day) is definitely nothing to sneeze at either. For now, I would not touch crude oil with a ten-foot pole.

Signing off,


 

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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