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Short interest climbs again

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It's nice to have company, but c'mon!

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Short interest for the period between mid-April and mid-May rose 1.54% on the NYSE and 1.91% on the NASDAQ. Short interest on both exchanges again set new records (last month was the old record).

The graph I've been using appears below. It uses January 2003 as an index year (for no reason than that was a complete year bull market and the first year where I collected data. I'm not certain the graph is anything more than informational, but I think it is worth pointing out the pattern of the indexed NADSAQ Comp (in dark blue) after each time it was eclipsed by the indexed value of the NASDAQ short interest (light blue).

There is a great deal of disagreement about whether the constant rise in short interest is due to an overcrowded bearish trade or structural changes in the market. In this most recent measurement period, one can toss in a third factor - the debut of the "Part Two" experimental portion of Reg. SHO (read more about this here).

SHO?

Let's address the SHO issue first. With less than two weeks to influence things, I doubt the newly-changed rules making it easier to short large numbers of stocks contributed to the rise in short interest - particularly a rise this large. Upon the initiation of Part Two of Reg. SHO, we began to track a selection of biotechnology stocks affected by the rule change. These stocks were selected because they were members of the NASDAQ Biotech Index (NBI) at the time the SHO Part Two rule was initiated. Whereas the average short interest in NBI stocks declined last month, average short interest in the 60 biotech stocks that share membership in the NBI and the SHO Category A or B lists increased. This is a trend worth watching, though I would hardly call it conclusive after only two weeks of data.

Overcrowded?

I am the first to admit that structural changes in the market have a bearing on the level of short interest. The rise of strategies - some computer driven and some not - that employ complicated hedging mechanics have dramatically affected the market. Some argue that because the increase in short interest is due to a hedged transaction it does not matter. I disagree.

If you hope to make any money in the market, you have to be leaning one way or the other. A perfect hedge results in a performance of zero. Additionally, these strategies are largely employed by professional managers, which means they must not only make money to get paid, they must make more money than the next fund (outperformance) in order to continue to survive.

I submit that there are far more people leaning short this market than ever before. A substantial rise in the market will catch these people leaning the wrong way, causing the record short interest to finally matter. Covering will result, accelerating what will necessarily already be a substantial rise in the market.

Structural?

Let's say I'm wrong about that point, however. There aren't more people leaning short and the consistent record levels of short interest is a mechanical side effect of new styles of trading.

I believe everyone would have to agree that a survey of managers would reveal different degrees of hedging. Manager 'A' might be less hedged than Manager 'B'. In a sustained market rise, Manager 'A' will outperform Manager 'B' because she is less hedged. Since outperformance is so important in this game, Manager B's larger hedge (even if he is net-net bullish) will be a drag on his performance. If he expects to keep the money he has under management, Manager B will have to shed his short-side hedge to remain competitive. That covering will accelerate what will necessarily already be a substantial rise in the market.

I've made it clear in past commentary that my view of short interest as a causative force behind market gains was incorrect. It is clear to me now, and has been for some time, that the levels of short interest are accelerants to any market gain. I strongly believe that when the overblown short interest begins to matter, it will matter a great deal and anyone on the wrong side when that happens will be torched but good.

Back to biotech

Short interest in the IBB, the iShare ETF for the NASDAQ Biotech Index (NBI), dropped 9.2% to 9.07M shares last month. Last month, short interest in the IBB was down 24%. The BBH, a HOLDr ETF approximating the AMEX Biotech Index, saw short interest drop 8.65%.

Finally, the short interest on the 158 stocks in the NBI at the time the short interest figures were calculated (it has since rebalanced) represents 11.38% of the total short interest on the NASDAQ. This is down from last month's 11.69%. Total short interest for all NBI stocks decreased by 5.3M shares (0.81%).

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No positions in stocks mentioned.

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