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Short Interest

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Brian mentioned short interest in an earlier post, and I want to follow up with some thoughts. While it is true that short interest is high, I would have to respectfully disagree that it is "uncomfortably high".

For the month ended July 15th, short interest on the NYSE declined 3.2% from what was seen in June. Such a drop is quite rare, as short interest has shown a secular rise since the 1940's, and went parabolic along with the market beginning in the early 1980's. In fact, since 1980 only 16% of the months to date have shown a month-to-month drop in short interest of 3% or greater. The closest recent comparison is January 2001, which showed exactly a 3% drop from December 2000.

Because total volume has also shown a secular rise, it is misleading to look at short interest alone. The most common way to correct for volume patterns is to create a "short interest ratio", which is the short interest figure divided by some type of volume reading. Usually, the ratio is constructed by using an average of the past month's volume, but volume is very seasonal, so I prefer to use an average of the past year. The theory behind the ratio, is that periods of high short interest show extreme investor pessimism, and should be bullish for the market going forward. The reason is, if the market begins to show some strength, those holding shorts will likely begin to buy back their shares, thus providing an additional source of demand. Conversely, periods of low short interest mean that traders have covered some degree of their short positions, often a sign of confidence about rising prices.

The chart below shows this short interest ratio:



The ratio has done a reasonably good job at timing the market long-term. We can see that short interest spiked higher near the bottom in late 1990, and kept rising as the market did. This is one of the few sentiment indicators which correctly stayed relatively bullish throughout the 1990's. Beginning in 1999, short interest tailed off dramatically, finally becoming extremely low (compared to recent history) and bottoming out in August 2000 as the market formed its long-term peak. From that point, short interest in relation to total volume rose steadily, finally peaking again in August 2002.

The fall recovery, and the rally through this Spring, has been accompanied by flat or declining short interest, at the same time average volume has continued its steady rise. Currently, the ratio between short interest and volume is at its lowest point since 1993. This is especially surprising considering the large number of convertible bond deals that have been brought to market over the past few months, as both May and June set new deal records, with a total of 101 deals closed according to ConvertBond.com. Hedge Funds represent one of the largest customers bases for convertible bonds. Hedge Funds buy the bonds and then sell the underlying shares short as a hedge. The fact that short interest has declined while convertible issuance has increased so dramatically raises my antennae since it may indicate more public short covering than previously thought. This would be a bearish indication for the market going forward.

It's important to keep in mind that there are still 7.8 billion shares short and outstanding on NYSE issues. There have been about 425 million shares covered (bought back) since the peak short interest in the summer of 2002. However, considering that total volume on the NYSE has been hovering around 1.7 billion shares daily, we could see an entire week of volume consisting solely of short-covering before it would be depleted. These 7.8 billion shares amount to around 2.2% of total shares outstanding for NYSE issues.

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