Short Interest Ain’t What It Used to Be

06/19/2007 12:00 am EST

Focus:

James Stack

President, Stack Financial Management

James Stack, president of InvesTech Research, says the extremely bullish readings we're getting from the venerable Short Interest Ratio are suspect because of changes in the markets over the decades.

[The bulls argue that] short sales and short interest ratios (the number of shares sold short divided by average daily trading volume) on both the New York Stock Exchange and NASDAQ Exchange have risen to high or record levels. This is a very bullish development that represents a potential "buying frenzy" as these short sale shares must be bought back.

25 years ago, we would have placed more credibility in extreme (bullish or bearish) readings from the Short Interest Ratio. However, since the early 1980s this ratio has become distorted by arbitrage and esoteric Wall Street products.

As early as 1987, investors were being misled by the Short Interest Ratio as it remained near record high (bullish) levels in the months leading up the October 1987 Crash. Yet again, in the summer of 1990, a bear market unfolded in all major exchanges with-you guessed it-the Short Interest Ratio at record high (bullish) levels.

As [the big 2000-2002 bear market] got under way, this Short Interest Ratio was rising sharply and giving investors a totally false perspective of what lay ahead. It wasn't until January 2001 that this Short Interest Ratio fell and started giving lower readings-which were still falsely bullish if compared to pre-1990 data!

So the NYSE Short Interest Ratio has failed miserably at the start of the past three bear markets-a good reason in itself to treat this tool with a healthy degree of skepticism.

Yes, a much greater number of shares are being sold short, but what if the average price of those shares has fallen sharply in recent years? That's exactly what has happened. Data analysis from The Leuthold Group shows the greatest increase in the Short Interest Ratio has come from the Standard & Poor's SmallCap 600 sector, where the ratio has jumped from 3.5 to 8.6 since early 2001.

Meanwhile, the Short Interest Ratio for the S&P 500 is actually lower (less bullish) than it was during most of this same six-year period!The average share price for stocks in the S&P SmallCap 600 Index is only 59% of the average share price for the S&P 500 Index. [This] could mean the Short Interest is seriously distorted to the high (falsely bullish) side.

[Meanwhile,] the number of hedge funds has mushroomed, along with their assets under management. According to Hedge Fund Research, in 1990 there were 610 funds controlling $39 billion in assets. Today, that number has grown to over 9,000 hedge funds wielding more than $1.5 trillion in long and short positions. By comparison, the total capitalization of the US stock market (Wilshire 5000 Index) is just over $15 trillion.

Together, these influences are clearly distorting the Short Interest toward false bullish readings. The question-which will be known only in 20/20 hindsight several years from now-is whether they have rendered this tool worthless.

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