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Short Interest's Overblown, Overblamed


Short-selling intensity is key predictor.


I hate to say I told you so... But, I told you so. A year ago, in our monthly (July 2007) report, my firm stated:

"We are concerned that SEC Chairman Cox is a bit premature in calling the uptick rule 'antiquated.' In the regulation SHO pilot test started in 2004, where short selling on downticks was allowed, no major stock market decline occurred. As money managers adopt strategies that include short selling, we think the lack of an uptick rule could exacerbate market meltdowns."

Here's a thought. Restrictive securities regulation most often occurs after market meltdowns. The Securities Act of 1933 and the 1934 formation of the SEC itself was a result of the market's collapse into 1931. The SEC tried to gain control of the equity derivatives markets from the CFTC after the Crash of 1987... and whatever happened to those circuit breakers enacted by the exchanges? Buying into those times (1933, 1934 and 1987) were great entry points. So, does the unwinding of securities regulations, like the uptick rule, mean we are at the other end of the market spectrum?"

Today, there's dramatic attention being paid to the supposed tightening change for short sellers on the part of Chairman Cox. In a (once again) hastily put together regulation, he's "clamping down" on the practice of short selling without having borrowed the stock to cover with down the road (a.k.a. naked short selling.) But... wait a second! Isn't that already part of that regulation SHO package of rules made a year ago?

"Regulation SHO, which became fully effective in January 2005, provides a regulatory framework governing short sales of securities and, among other things, includes the following:

"A locate requirement, which requires that before accepting or effecting a short sale order, brokers and dealers must (i) borrow securities, (ii) make arrangements to borrow securities, or (iii) have a reasonable basis to believe that securities can be borrowed in order to make timely delivery."
SEC press release, June 13, 2007

I understand that "rumor mongers" are undesirables. But focusing on the practice of short selling isn't addressing the problem. Enforcing current legislation is.

Rumor mongers need to be found and prosecuted. Traders manipulating markets by rumor, misinformation or even terrorism are pernicious and are crimes against a better marketplace and a safer homeland. Middle-of-the-night rule changes, such as the latest from Chairman Cox, are counterproductive... especially in terms of confidence. This latest rule change... er... clarification only highlights the SEC's inability to enforce its rules. Not a confidence builder in the markets.

I can think of a helpful rule change: Let CEOs publicly comment on their companies during the "quiet period" before earnings. So long as such information is publicly released, more information is better than none at all. Yesterday, the head of Fannie Mae (FNM) hid behind the "quiet period" rule when asked if there was any fundamental scenario for buying its shares.

The best defense against misinformation is the truth. To paraphrase Jack Nicholson, the market can't handle not having the truth. Lack of information leads to lack of confidence.

Along with the argument focusing on the lack of confidence is the reported "record" short interest. Folks, I've said it many times before and I'll say it again: Record short interest means nothing. It has as much value as saying there's water in the ocean.

Short interest is a subset of volume. For various reasons, volume is in a perpetual uptrend due to splits, increases in authorized shares, etc. Saying short interest is at record levels is essentially saying that volume is at record levels. There's no investment or market confidence factor to be gleaned by this statistic.

Short-selling intensity, on the other hand, is the key. Short intensity relates short interest relative to overall trading volume. There are 2 points to be made here:

The above chart shows the count of heavily shorted Type issues (1s and 3s.) Short selling intensity is above average... but not at extremes, and not even close to the high levels seen at times in 2005, 2006 and 2007.

Moreover, the above charts show that short selling intensity is below average in the banking sector and in Fannie Mae's industry group.

Generally, short interest tends to lend support to price action, though there are times when short sellers can be correct. The existence of short sellers is support for stock prices, because short positions must eventually be covered.

Perhaps Chairman Cox should focus on freedom of fundamental information, so that short sellers and stock buyers can make more informed decisions, and so all can sort fact from any fiction put out there by rumor mongers.
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No positions in stocks mentioned.

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