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Random Thoughts: A Signal That Bears Watching

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Short covering has dominated the recent rally.

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Editor's Note: Todd posts his vibes in real time each day on our Buzz & Banter.

Late Friday, I received the following information. While no one signal or data point is omnipotent, I share it with ye faithful, for it explains a lot. Please note that as I did not receive this from the actual source, I cannot entirely vouch for it's validity.

"Morgan Stanley (NYSE:MS) explains that among its equity long-short fund activity, the short activity (the net of shorts added and shorts covered) reached a minus-2 Z-score, indicating massive covering over the past 20 days.

"The last three times this occurred were April 2010 (S&P (INDEXSP:.INX) then fell 13% in eight days), July 2011 (S&P then fell 19% in 23 days), and Oct 2011 (S&P then fell 10.5% in 20 days).

"Across sectors, Consumer Discretionary has been the most covered over the past week and month. Due to heavy covering, Discretionary short activity fell below a minus-3 Z score as of yesterday (Thursday, May 16; now the highest long/short ratio of all sectors). It is worth keeping in mind, they add, that historically speaking, the sector with the highest long/short ratio has often gone on to underperform over the following six to 12 months.

"This covering has driven median net leverage up to 64% (its 97th percentile of post crisis levels).

"Money on the sideline? Not so much; massive short-covering rally -- YES!

"Quoting a Morgan Stanley representative: 'Long/short funds have been consistently covering over the past month, which has driven gross lower and net higher. One way we measure long and short activity is by looking at the activity Z scores on a rolling basis where the past 20 days' cumulative activity is compared to all 20-day rolling periods over the past 12 months. On this basis, the short activity z-score reached -2 as of this week, indicating significant covering by L/S funds. Other times we've seen a minus 2 z-score: late April 2010, early July 2011, and late Oct 2011.

"'Looking at the long activity, it had been relatively paired off (i.e. longs bought approximately equal to longs sold), prior to a small increase very recently. This illustrates that most of the buying has come from shorts covered rather than longs bought.'"

Maybe something, maybe nothing, but it's a data point that would certainly make sense. As always, this is but one piece of a very complicated global market puzzle.

Random Thoughts:
  • Expiration hangovers-when dealers square their risk following expiration-typically lasts a few hours the following Monday (today) before a truer tenor emerges from the tape.
  • In full disclosure, I will communicate that I am currently trading around a short bias. Particulars of that effort-along with actionable ideas from folks much smarter than I am-are communicated in real-time every day on the Buzz & Banter. (Click here for a free two-week trial.)
  • S&P 1666-vs. S&P 666 in March 2009-isn't lost on me; it felt wrong to buy then, just as it feels wrong to short now. The "other side" to that trade, of course, is the chart below; if this is the blow-off, the breakout (of the trend-channel) was a necessary precursor to the move. See both sides; always see both sides.
  • If you're a history buff, you'll get a kick out of the fact that the Dow Jones Industrial Average (INDEXDJX:.DJI) is in the midst of the longest streak without a three-day decline since 1900 (when Grandpa Neal Glassman was just a teenager). Hat tip to Professor Jeff Cooper on that stat.
  • While one could argue that each day is independent, much like a roulette wheel in a casino, the law of averages, or a reversion to the mean, should kick in at a point. Timing is everything, and I will again offer that any and all conversations regarding this tape should have an asterisk on it as we are in uncharted waters as far as the drivers of the market.
  • Speaking of Coops, please make sure you read his terrific 1929, 1987, and 2013: Three of a Kind?
  • The eye-popper disconnect-other than social mood vs. the stock market-is the price action in commodities vs. the price action in stocks, per the chart below.
  • Perhaps the chasm continues to widen-and perhaps the parabolic frolic in stocks ascends to the point where it loops around like the Revolution at Magic Mountain. And while I always respect the action-the banks, breadth, and leadership act pristine-I won't defer to it-not here, and not ever. If we did that, we would buy high and sell low, over and over and over again.
  • I thought I knew what love was the day I got married. I thought I knew what love was when my daughter Ruby was born. I thought I knew what love was this past Friday, as I watched our three kids play in the backyard to celebrate Ruby's second birthday. Today, I finally know what love is as Jamie and I have killer tickets to Tom Petty and Stevie Nicks at the Beacon and, as I am unable to go, I insisted she take one of her buddies in my stead. Petty is 'our' thing, but she deserves the smiles after the month I've put her through.
And finally, an update from the front…

As many of you know, I had a total hip replacement on April 30. No great shakes as these things go; I've had congenital dysplasia since birth and it was time to swap that sucker out. The first stage of recovery is scheduled to finish six weeks post-operation, which is June 12. This will likely cause me to miss my nephew's Bar Mitzvah in Israel, but in his own sweet words, "Your health is most important Uncle Toddy; that's all that matters."

Last Thursday, I had a meeting scheduled in NYC that I didn't want to miss. My wife insisted that before I made the 45-minute commute, we should head out the night before to test my tolerance. She took me for a ride and we walked about 100 yards to a restaurant, only to walk in and realize that there wasn't anywhere for me to sit comfortably. At that moment, I began "feeling it," and we agreed that it would be best for us to go home.

While she was pulling the car around, I went down. Throughout my life-let's call it six or seven times-I've suffered from something called vasovagal syncope, which triggers a loss of consciousness. This occurred from a standing position, so I consider myself very lucky that no serious damage was done. I did, however, smack my head pretty hard on the pavement, which required an ambulance ride to the ER. I'll tell ya, you haven't lived until you've been strapped to a wooden board and driven to a hospital two weeks after a hip replacement.

I share this for one reason: to explain my sporadic writings of late. I'm feeling much better (my wife says it knocked some sense into me) and I look forward to a full recovery in short order. No, it hasn't been the smoothest of stretches these last few weeks but in the words of the wisest man I've ever known, "This too shall pass."

Good luck today.

R.P.

Twitter: @todd_harrison

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Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

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