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The Most Bullish Readings in History (or regulatory anamoly?)


What do they know that I don't?


Each week, the NYSE releases information to the public regarding the interaction of orders between the public and members of the exchange. The data is reported on its website and in periodicals such as Barron's.

For many decades now, analysts have watched this data in an attempt to get a clue on what the "smart money" specialists were doing as opposed to the "dumb money" public. In their roles as market makers, specialists are obligated to take the other side of most trades - so if the public is buying heavily, then specialists must sell stock (sometimes going short if they don't have stock in inventory) in order to meet the demand and keep an orderly market.

When the data showed that specialists were shorting stock heavily, then either they were especially pessimistic on the market's prospects, or the public was buying heavily. For many years, that was a consistently good signal to side with the specialists and become more defensive. Conversely, when specialists were not shorting much at all, and the public was selling heavily, then it was a good time to buy along with the smart money.

Over the past couple of years, this data has been skewed to a large degree by the increasing use of program trading. The correlation between program trading and specialist short activity is -.87, and given the number of data points we have it is virtually impossible that is due to chance alone. As program trading has increased, specialist shorting has decreased.

Still, the latest two releases from the NYSE have been astounding. The public has been shorting more than 3 times as many shares as the specialists, which is unheard-of in the 60 years of data I have. The two weeks that approach the current one in terms of magnitude were after 9/11 and August 13th, 2004 - pretty good times to be buyers along with the specialists.

There have been a couple of new regulations that have come online recently that impact short selling. Perhaps those new regs are causing distortions in the data? I am on the outside, so I have no idea. The best bet is to go to the source, the specialists, and get the straight dope.

I want to share with you an email I received from specialist firm Van der Moolen Holding NV which I think sheds some light on the matter:

"...if anything the short sale rules are being liberalized. We suspect that the decline in short sales you have noticed is simply the result of market circumstances. However, the "threshold" rules may have forced them to cover some long-term shorts. You are probably aware that specialists concentrate pretty exclusively on short term strategies, but if there is buying interest in an illiquid share that is difficult to borrow (for instance, a preferred issue), in the past they might have shorted it "naked." This is no longer possible for periods longer than twice the normal settlement cycle. However, we doubt that covering such positions would be sufficient to cause the change you have noticed."

I think that's pretty clear. The new regulations do not appear to account for the recent historic readings in this data. Perhaps these readings are due mostly to convertible arb funds buying GM bonds and shorting the stock...but it's something that should be looked into further, because if these readings are "real", then it further confirms that this is one of those times.

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