The Market Doesn’t Make Sense

01/25/2012 6:30 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

With the chances of a recession in Europe still high, MoneyShow’s Jim Jubak shares his thoughts on why the US market is so strong.

This market doesn’t necessarily make fundamental sense. You’ve got the World Bank going out there and cutting its estimates for global economic growth in 2012. You’ve got Europe sliding into a recession…so why is the stock market going up?

We’ve gone from 1,205 in mid-December to 1,308—why is this happening? Well you can get some inkling of that if you look at some of the stocks that have been going up.

One that I was looking at the other day is the St. Joe Company (JOE). They were a timber company, and is now mostly a Florida real estate company. If you look at the chart, what you see is the stock price chugging along, not going up a whole lot—there’s no visible recovery in the housing industry to drive it up.

And then all of a sudden in late December, early January, it goes up from this to this. You’ve got this absolutely amazing rocket taking off. If you look at that and you say, well, what’s going on at St. Joe? Nothing in particular. Yeah, you’ve got some news about the housing market that says maybe people are getting more confident, and homebuilders are getting more confident, but nothing that really explains this kind of chart.

What does explain this kind of chart is if you look at what’s going to align with something called short interest. Short interest is a measure of how many shares of the stock have been borrowed by people selling the stock short.

When you borrow, you borrow shares with the idea that you’ll pay them back later when the stock has gone down, so you’re basically betting that the stock will go down, because that’s how you make your money. You borrow them now, you repay the same shares later at a lower price, and you make the spread.

If you look at the number of shares out and you go back to say, let’s say October, you had about 18 million shares of St. Joe borrowed. This means that they were then sold in the market. By mid-December, we were down to 15.5 million to 16 million.

That big swing, that 2 million shares, means that those people who were short have gone into the market and bought shares to cover their positions. That’s how you go about getting out of a position, you have to buy shares to cover it.

As your short interest shrinks, as it falls, it means there’s more buying by people who decide, well, "I made my money being short and now it’s a good time to cover so I won’t be exposed to losses." Does this mean necessarily you think the stock is going up tomorrow? Nope. Does it mean that you think the housing market has turned? Nope.

It means that you’ve done a sort of risk-benefit analysis that said "Hey, the easy money has been made. I don’t need the risk that maybe there’ll be a spike like the one we’ve had currently, so I’m going to sell." You remember that we’ve still got around 15 million to 16 million shares of St. Joe borrowed by short sellers, so it’s not like this position has disappeared entirely, but that swing certainly helps explain why this stock has moved up.

That swing also explains why a lot of other stocks have moved up. If you look at housing, the homebuilder sector as a whole, its one place. You look at technology shares, it’s another place where the short interest has declined for a lot of stocks powering the market right now.

And if you think about it, the question for you as an investor is "OK, that’s one of the reasons for this 100-point move in the last month.  How much fuel is left, and what do I think short sellers are going to be doing over the next month?"

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