A Bearish Market Shift?

08/04/2006 12:00 am EST

Focus:

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Options expert Bernie Schaeffer notes "recently, a number of "momentum" names, saddled with heavy short interest, have become a virtual minefield for the bulls. Here’s a look at his latest commentary…

"While we generally view solid short-interest ratios as a positive contrarian sign, the indicator can only be interpreted as such if the underlying technical trend continues to run counter to the sentiment. Short interest on a stock that is breaking down isn't as attractive, contrarily speaking, as continued short additions on a stock that retains the (up)trend as its friend.

"Heavily shorted momentum plays Wynn Resorts (WYNN NASDAQ) and Zoltek Companies (ZOLT NASDAQ) boast short-interest ratios (SIR) of 9.45 and 5.76 days to cover, respectively. And more than 17% of WYNN's float has been sold short, and 28% of ZOLT's available float is devoted to the short side.

"The technical health of the equities themselves, on the other hand, has deteriorated markedly in recent months (although they remain above long-term support zones). WYNN rallied more than 90% between late September and early April, but after several failed attempts to clear the 80 mark, the stock succumbed to downward pressure in mid-May and has spiraled 21% lower since. This decline has brought the stock beneath its ten-week and 20-week moving averages, which have themselves completed a bearish crossover.

"ZOLT more than quadrupled in price between early December and mid-May and has shed 40% of its value in less than three months' time. ZOLT shares are also now perched below their ten-week and 20-week moving averages, which are currently in the process of forging a bearish cross.

"It would not be a huge stretch to conclude that we are moving into a more bearish market environment. The short sellers are starting to win the battles among momentum issues, making these names a very dangerous game. Meanwhile, overloved large-caps continue to gasp for air, only to break down even further. While this is not a pretty combination, I'm not yet willing to sound the bearish alarm just yet. The S&P 500 Index (SPX - 1,276.66) remains above long-term moving average support, and huge put open interest continues to guard against any destructive downside.

"But such market behavior suggests that one, at the very least, should have a list of stocks to avoid at all costs from the long side if we find ourselves in a more bearish environment. And for the more aggressive traders who employ shorting as part of your overall strategy, now might be an ideal time to research some shorting candidates."