High Short Interest the Achilles' Heel of Bears

By: Henry To | Fri, Jul 6, 2007
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Dear Subscribers,

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:

Betting the House - Swiss franc and euro-denominated loans are popular in Eastern Europe. Percentage of all corporate hnd home loans in a foreign currency.

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:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to June 15, 2007) - For the month ending June 15, 2007, total short interest on the NYSE increased 706 million shares to 12.47 billion shares. The monthly increase represented the third greatest monthly increase on record, while the 12.47 billion shares outstanding short interest also represented an all-time high. Moreover, the latest 12-month increase in short interest just hit a record high of 37.2% - a high which even surpassed the highs we witnessed during the 2000 to 2002 bear market.

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:

Nasdaq Short Interest vs. Value of NASDAQ (September 15, 1999 to June 15, 2007) - Short interest on the NASDAQ rose a dramatic 770 million shares in the latest month and is now at 9.17 billion shares - a record high. The 12-month increase in short interest is now at 27.58% - a rate of increase not witnessed since September 2001 (not including the 30.22% reading we got last month). In the short-run, the amount of short interest outstanding is a horrible timing indicator, even though over the longer-run, such an increase in short interest is bullish for the stock market, especially since this also confirms the record high short interest on the NYSE.

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.

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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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