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Short Shrift



The American Heritage® Dictionary of the English Language defines "short shrift" as follows:

NOUN:1. Summary, careless treatment; scant attention: These annoying memos will get short shrift from the boss. 2. Quick work. 3a. A short respite, as from death. b. The brief time before execution granted a condemned prisoner for confession and absolution.

We especially like the last definition, because it goes to the heart of our two factor squeeze play model. When price moves against a majority position, the majority is "executed" without much mercy. In the case of a majority short position, the execution comes in the form of rising prices. Such "capital" punishment forces shorts to cover their positions, spurring the flow of rising prices.

In our two factor model we observe 1) a majority sentiment at risk, and 2) price action contrary to the interests of the observed majority.

One of the indicators we use to judge sentiment is short interest. If short interest is on the light side, we consider the bulls to be the majority at risk; when short interest is heavy, it's the bears who are at risk.

Interestingly, short interest analysis has itself been given short shrift over the last decade or so. This is because the advent of hedge fund and arbitrage activity has soared to levels that have made it more difficult to set parameters for short interest rankings. Let's take a closer look.

The above chart shows the NYSE total short interest from 1931 on a logarithmic scale. The March 2005 report of short interest from the NYSE shows that short interest is at record levels. This may seem dramatic, but as this chart clearly shows, many short interest reports are at record levels. How can this be?

Since 1931, NYSE monthly short interest reports have been at record levels 170 times (out of 886 months, or 19.19% of the time.) Roughly 1 out of every 5 monthly NYSE short interest reports are records - but not lately!

This month's record NYSE short interest is the first record in 30 months (since October 2002.) Short interest has been at a record only 3.33% of the last 30 months. In contrast, during the 30 months prior to October 2002, short interest was at a record for 22 of those months, or 73.33% of the time.

Record levels of short interest certainly reflect increased willingness to bet against the market. Such willingness is usually a direct response to weak price action. Therefore, the creation of increased levels of short interest is a function of weak price action:

Note how the clusters of NYSE record short interest appear during periods of weak price action. The key to short interest analysis is to determine excess levels of short activity, and to observe an upturn in price action. Record short interest levels in and of themselves are insufficient measures in determining excess bearishness. The first step is to normalize the short interest data.

Short interest is a subset of volume. It is expressed in "shares of stock." The latest NYSE short interest report shows 8,419,194,508 shares that exist as open short trades. Because short interest is a subset of volume, we use total volume as a first step in normalization:

The above logarithmic chart shows the last 32000 days of NYSE total volume from 1891 to the present. It is the nature of volume to increase over time. Stock splits, growth in the number of securities (and security types) and technological efficiencies contribute to this trend. Records in volume (trading activity) are therefore frequent. Records in volume give few clues regarding sentiment. We use volume to normalize the short interest data:

The short interest ratio is the result of dividing short interest by average daily volume. The above chart of the NYSE short interest ratio does not appear to be very "normal", but it does describe the increased use of short interest with the onset of derivative products that started in the early 1980s. From our point of view, the NYSE short ratio is of less use than other, more specific measures of short interest. However, it does show that short interest (normalized for volume) dropped off sharply with the start of this decade. The recent recovery, though not a record, is nevertheless substantial - certainly enough to support a Q2 rally if price action improves.

The picture becomes less dramatic when looking at the short ratio of the component issues of key indices:

The short ratio of the S&P 500 issues is a far cry from levels seen in the 1990s. This suggests that few are willing to bet against larger cap issues. An increased willingness to bet against S&P 500 issues kept the average going from the 1987 crash until 2000.

The short ratio of the larger cap NASDAQ 100 issues (above) is almost at its lows.

The short ratio of the S&P 400 Mid-Cap issues is well above its lows seen in 2000, but below the level seen in 2003.

The short ratio of the S&P 600 Small-Cap issues is perhaps the most compelling. While the ratio is below its peak, that peak occurred in 2003. The current ratio is above pre-2000 readings. This suggests that the bulk of negative betting is in smaller capitalized issues. This is a factor in the superior relative strength of small cap issues.

We look at "individual issue" short selling by determining where in each stock's history its short ratio lies. A 100% short rank means that its short ratio is trading at a new 5-year high, a 0% short rank means its short ratio is at a new 5-year low. This enables us to compare one stock's short intensity to another on a common scale (0 to 100) and to easily composite short ranks for industry groups and sectors.

The above chart shows the average short rank for the electronic technology and technology service sectors. Both of these sectors have seen a significant jump in short intensity over the past two months. However, our short intensity rank is not cap weighted. Is it true (as the S&P 600 short ratio suggests) that the bulk of short intensity is within smaller cap issues?

The above chart shows the market cap of all electronic technology and technology service issues sorted by our short intensity rank. Clearly, the higher the short intensity, the lower is the market cap.

Our conclusion is that there is enough short intensity to support a Q2 rally, but nothing is in conflict with the larger picture of a bear secular cycle. Larger cap issues likely will continue to under perform smaller issues in a potential Q2 rally.

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No positions in stocks mentioned.

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