New Breed of Short Sellers Hits Market

05/08/2008 12:00 am EST

Focus: MARKETS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, founder of Schaeffer’s Investment Research and editor of the Option Advisor, says short selling has gone mainstream, affecting the behavior of markets.

Aggregate short interest on the New York Stock Exchange reached four billion shares in 1998 and eight billion shares by 2002. And now it has again doubled to 16 billion shares.

The activities of the “new shorts” (and by this I mean well-capitalized hedge funds and traditional money managers) have been of great interest to me. There have been numerous examples over the past year of heavily shorted stocks whose share prices have been savaged by the market, due in no small part to the willingness of these deep-pocketed shorts to “double down” and add to their positions.

In addition, the new shorts are much less prone than in years past to flee when positions move against them, so the short-covering rallies fueled by panicked short liquidation have become somewhat scarcer.

Increasing pressure from the short trade helped keep stock valuations from getting out of hand during the bull phase, and short covering/put liquidation have been a contributing factor to the event-related pops in recent weeks, [especially] on earnings announcements.

I also find it interesting that Fidelity started up its 130/30 Large-Cap Fund (FOTTX) with an inception date of March 31st. (130/30 funds typically have leveraged long and short portions of their portfolios—Editor.) Not only is this a pretty strong indication of the “mainstreaming” of short selling, but it’s difficult given the timing to believe that a major bear run is now in the cards. For what it’s worth, the crude oil US Oil exchange-traded fund (Amex: USO) was launched in the second quarter of 2006 ahead of a pullback in oil prices that approached 40% before the bottom in early 2007.

Joe Sunderman [of Schaeffer’s Investment Research recently] discussed the unprecedented bearishness of the financial media, as evidenced by the astounding number of bearish magazine covers. He bluntly stated that “we have never seen such an onslaught of negative cover stories in all our years of tracking the market.”

I believe this “mega-bearish” media tilt reflects the likelihood that the bad economic news has already been reflected in this market, and that the upside potential from a combination of short covering and the movement of some of the now huge store of sideline money back into the market comfortably exceeds the downside risk.

It is also interesting to note that the CBOE Volatility Index (VIX) has recently moved below its 32- and 40-week moving averages after over a year of trading above these levels. So, just as the headlines are screaming “fear,” professional options traders are becoming a lot less fearful. And I’ll go with the opinions of the professional options trading community over those of the headline writers any day of the week.

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