Spotlight:  September 7, 2001
The Long And The 'Short' of It
By Brady Willett

Don't get me wrong the proverbial 'fat lady' continues to warm up her vocal chords as the Dow continues to drop.   Moreover, the U.S. equity markets are still on track for a complete collapse by years-end.  However, as stock prices head off into the abyss certain market developments could permit a bullish spike in prices.

To begin with, Nasdaq short-selling interest (denoted in total shares short in chart) recently eclipsed the record high set back in April: as you may remember back in late April the bulls found a reason to buy, and shorts found a reason to cover.  As such, in hindsight it can be observed that the flurry of short covering helped embellish the brief 'summer rally'.  That said, short interest began to increase late in the summer, and since August 15 one would suspect that short selling has intensified further. Accordingly, a flurry of short coverings may loom even larger now than back in April. 


Short interest on the NYSE has also set records in recent weeks.  More specifically, total shares short are currently 1.7% of total shares on the NYSE, or an extremely high level when looking back at the last 20 years. With this in mind, could increased short exposure be telling us that a short covering rally is imminent?  Many would argue yes.

The flipside to this argument is that shorts have held strong since April, and as outflows from equities intensify short sellers will gain the ability to cover at their leisure. As an example of this type of market behavior, Barrick sells forward gold contracts when prices are high, and covers positions when prices are low – all that is needed is a liquid, and range driven gold market for Barrick to achieve success.  By comparison, shorts in 2001 have sold the market when prices rise for no reason, and begin covering when the averages near the bottom of their ranges. As such, 1.7% short interest on the NYSE could be a meaningless number if no serious rally develops until April's lows are struck – or the point when short sellers may begin pulling money out.  

In sum, short sellers are a more important party in today's market than they have been for many years.  Furthermore, fluctuation in short interest, and the psychological impact subsequent price movements may have on investors could decide where the bottom to this market rests. 


If prices do spike because of the onslaught of short covering sidelined investors may get excited – the result would be a frantic attempt from both sides to buy as prices spiral higher.  Needless to say, this would be a temporary cheerleading session if the economy, and earnings situation did not readily improve. Moreover, if short sellers initiate the price spike they would, in fact, possess adequate funds to enter short again after the market chasers arrive. 

The Usual Suspects
There is little doubt that hedge funds are where a great deal of short selling has originated.  With this in mind, it is worth remembering that many hedge funds made leveraged purchases of U.S. equities in 1999, and suffered severe losses in 2000 (hello Mr. Robertson, and Mr. Soros).  This may be an important point to remember because hedge funds have gained more clout (capital) this year, and quick changes in equity prices could cause increased systemic risk – hedge funds could quickly emulate early 2000 losses if the market churns higher.  By contrast, as hedge funds are finding new capital mutual funds are encounter tighter capital flow -- an important trend when considering the regulatory differences between the two entities. Hedge funds in nature go short, trade derivatives, and leverage - things not done with such ease with most mutual funds.

So let us welcome back the short seller with open arms: they beat to death what deserves to be beaten, and can provide patient investors with attractive lows.  While the long story is that stock prices will inevitably retreat below April's lows – the short story is that the capital that has decided to sell stocks first will determine how volatile the ride down is.


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