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A Look at the Specialist Short Ratio


This is a broken relic that should not be relied upon.


A couple of weeks ago, we looked at an indicator (margin debt) that has perhaps been abused by those bearish on the market. It had been a tool in their box, waiting to be presented whenever asked to justify their position.

As we saw, though, it's not quite that simple. The bulls, too, have a similar indicator they tend to trot out at the slightest provocation. Like margin debt is for the bears, this measure has been a poster child for the bullish case, and I believe wrongly so.
This week, we're looking at the Specialist Short Ratio.
Specialists have been in the media quite a lot lately, what with charges of front-running customers and their possible obsolescence given the NYSE merger with an electronic exchange.
A specialist has in theory a very simple job – they are charged with keeping an orderly market in the stocks in which they make a market. If there are too many buyers, then the specialist has to find a seller; if there are too many sellers, then they have to find a buyer.
In reality, it's not nearly that simple. If buy orders overwhelm available sellers, then the specialist is forced to cover the rest of the orders out of their own account so prices don't run away to the upside. In a market panic, the specialist has to buy stock to facilitate sell orders. Although they have sophisticated controls for hedging away the risk they take, they do have to take risk, and thus have to be extremely well-capitalized.
The NYSE, on a weekly basis, reports how much stock has been shorted by specialists, the public, and other NYSE members. The Specialist Short Ratio is just the total number of shares shorted by specialists as a percentage of all short sales.
Because of their position at the center of the stock-trading universe, specialists have the best information of any market participant (or at least they used to…see the "challenges" section below).
The specialists are normally called "smart money" because of their position. But their buying and selling activity is not necessarily a function of how smart or market-savvy they are, rather it is a function of the supply and demand for stock from the public that is the driver of their decisions.
So specialist activity is more like a barometer of what others are doing than a reflection of specialists' own beliefs about future market prospects. Still, no matter what your interpretation of it, historically when we saw specialists shorting a small amount of stock relative to the total, the market had a tendency to rise going forward. For decades, when specialists' shorts were 30% or less of the total, the broader market tended to rally strongly over the ensuing months.
On the other hand, when specialists were making up the bulk of short sales, then the market often fumbled going forward. From the 1940's through early 1970's, specialists sometimes made up 70% or more of the short sales, but since that time we rarely saw them account for more than 50%.
The constant innovations in real-time reporting of sitting orders and automatic executions have made the specialists less of a force than they used to be. Instead of seeing (and semi-controlling) a vast majority of order flow, they now see only a portion and control just a trickle.
Due to the reasons listed above, watching specialist data has become an effort in futility, at least in terms of its utilization in forming a market forecast.
Consider program trading. These large, semi-automatic buy and sell orders have become an increasing fact of life in today's markets, often making up 25% or more of total NYSE volume. This has affected the specialists' role as well. The chart below is a plot of the Specialist Short Ratio against program trading statistics for the past five years.
Taking the Specialist Short Ratio values at face value, we would have to conclude that we're at the most bullish period of all time. Specialists have never, over the past 6 decades, shorted less stock than they have been over the past couple of years.
Historically, when specialists accounted for only 30% or so of total short sales, it was often in a time of panic by the public. But since 2004, nearly every week has seen a Specialist Short Ratio under 30%. Over the past five months, the ratio has averaged an anemic 15%. This is unheard-of.
But I don't think we can take this at face value. Market dynamics have changed so much that I believe it has rendered this particular indicator irrelevant. Mostly program trading, but other innovations too, have wreaked havoc on a formerly reliable gauge of supply and demand for stock, and it's a mistake to think that we're at the most bullish time in 60 years based on an indicator that is probably broken forever.

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