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Staying Aware of Short Interest in the Market


Short interest declines are music to the ears...


The FOMC rate decision caught me by surprise. I didn't think the FOMC had it in them to do the right thing at the right time. It proved the FOMC learned the lessons of 2000-2001 very well and did not repeat the same mistake Alan Greenspan made at the end of 2000. He sent the entire economy into a recession when he decided to wring the last bit of speculation out of the stock market by not lowering rates at the end of 2000. Yes, he got unlucky when the nascent 3Q-2001 recovery was terminated by the events of 9/11, but the pain in the first two quarters of that year was not necessary.

I can quibble with the FOMC's discount window action as the 50-point Fed Funds target rate cut would have been enough of a signal all was well, but the desired psychological effect was made. The FOMC wasn't going to let the global macro bear funds break the equity and credit markets. For that matter, neither were the rest of the world's major central banks.

Is the current situation permanently sustainable? That's a good question. There is no doubt there are unsustainable aspects to the current financial system. There is enormous liquidity sloshing around and debt levels are high. Absent some exogenous shock, however, waiting for that lack of sustainability to make your oversized short bets pay off is a losing trade. In what's become a legendary MIM panelist comment, Tony Dwyer, Chief Market Strategist at FTN Midwest Research, notes: "It is a certainty the sun will burn out, but it is a bad trade."

Hedge funds have been selling the bejeebers out of equities. You can see this directly in the short interest data released each month (which will go to twice a month shortly). Professors Zucchi and Succo consistently caution me short interest data are no longer of much interest as they are almost exclusively driven by hedging transactions. They make good points and while I don't fully agree, their POV is worth keeping in mind when looking at the numbers below.

The growth in short interest is striking. Here are the numbers from 2003 forward:

Since January 2003, short interest has more than doubled. In the same time, the value of the NASDAQ Composite has gained an impressive 54%. On one hand, this could be read to prove Prof. Zucchi and Succo's point. On the other hand, it can denote we have an awful large contingent of permabears out there. At the very least, it shows how crowded downside trades are.

Since 2004, the bear case has been increasingly prominent in the financial media. We're at the point now where it dominates. I find it exceptionally fascinating that when the market really appears to run into trouble, short interest declines dramatically. Below is a graph I used to run once per month in these pages I think you'll find interesting.

Click here to enlarge.

Note particularly the relationship between the light blue and dark blue lines. Whenever the light blue short interest line arcs above the dark blue NASDAQ Composite line, an initial depression in equity prices is more than made up for by resulting gains. Several months back I noted if this pattern holds in this cycle, the NASDAQ Comp would easily crest 3000. The pattern is slightly different this time, perhaps due to the sheer magnitude of the gain in short interest, so it will be interesting to see how it resolves.

The other fascinating thing about the recent short interest activity is short interest on both the NASDAQ and the NYSE gained one billion shares April to June. Once the market turned south, short interest on both exchanges dropped a billion shares July to September. Coincidence? Unlikely.

One thing I continually stress when I write about biotech is that most people fail in their initial forays into this sector because it is so different. The stocks behave much different, short interest provides a very different signal, and the options (especially how they interact with equity prices) act differently. As a number of biotech funds went out of business this summer, we noted some relatively strong short covering in the biotech space. In fact, short interest in the NBI was down 10.3%, the biggest monthly drop since we started tracking it in 2004. Interestingly, that comes just three months after the 10.2% gain we saw in June, the largest gain we've seen since we started tracking it in 2004.

Here are the top 16 NBI companies ranked according to short interest as a percentage of their float.



Percentage Float Short

DNDN Dendreon 38.65%
SLXP Salix Pharmaceuticals 31.19%
CVTX CV Therapeutics 27.66%
MEDX Medarex 26.43%
MNTA Momenta Pharma 25.72%
SCRX Sciele Pharma 24.71%
FLML Flamel Tech 23.84%
MNKD Mannkind 22.99%
ENZN Enzon Pharma 22.72%
VIAC Viacell 22.57%
GTOP Genitope 21.97%
PPCO Penwest Pharma 21.87%
AGEN Antigenics 21.83%
AGIX Atherogenics 21.65%
GTXI GTX Bio 20.64%
MDVN Medivation 20.23%

Personalized Medicine Creeps Forward

It seems like ages ago when I first heralded the Death of the Blockbuster Drug. I (thankfully) noted at the time this would be a long process that would meet with significant resistance from the entrenched regulatory and product development communities.

I did set up a few signposts, however. I'm revisiting this now because one of those signposts had some activity this month.

The FDA and "several leading drug companies" announced the formation of a non-profit corporation called the Serious Adverse Events Consortium (SAEC) to examine genetic-level markers related to adverse drug reactions. This is a huge step towards the rise of personalized medicine.

One of the biggest promises of personalized medicine is dramatic increases in the therapeutic index of drugs. For those not familiar, the "therapeutic index" is the relationship between a drug's benefit and risks. Mentally, you can picture it as a fraction with drug benefit as the numerator and drug risk as the denominator. The higher the benefit and the lower the risk, the higher the therapeutic index of the drug.

The best way to increase the therapeutic index of a drug is to give it only to those who will derive some benefit. Herceptin is the prototypical example of this approach. Only patients with sufficient levels of HER2-neu are given the drug, increasing its therapeutic index significantly compared to if it was just given to everyone (which Genentech (DNA) tried at first and failed).

The flip side is to not give the drug to someone who will be disproportionately harmed. If there can be found genetic markers predictive of atypical adverse events, and tests can be validated for these markers, then the therapeutic index will also increase for that drug by collectively reducing overall risk.

It must be understood there is no such thing as safe drug. Give even the most benign drug to enough people and it will eventually maim a few and kill some. If you can identify, in advance, which people are at risk to be killed or maimed, that is a huge advance in medicine.

The cynic in me notes that the number of people excluded by such tests for susceptibility to side effects is likely to be significantly smaller than the number of people excluded by tests for "susceptibility" to efficacy. The reality is both sides of the equation must be dealt with affirmatively by drug companies. Only include patients that are likely to be helped by the drug based on some validated test. After that patient subgroup is identified, then test for susceptibility for serious side effects.

The gains in therapeutic index generated by that kind of dual testing are where the industry is eventually moving. The focus on adverse events is a good first step.

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