Record Short Sales & Liquidity Bubbles

Bloomberg is reporting Short Sales Break Record on NYSE; Market Bulls Get More Bullish.

Short sellers are betting against U.S. stocks like never before as the Standard & Poor's 500 Index approaches an all-time high. That's making some of the biggest bulls even more optimistic.

"What the short seller appears to be doing is doubling down," said Kenneth Fisher, who oversees about $40 billion as chairman of Fisher Investments in Woodside, California. "You love to see it, because if you believe there is a basic driver to the bull market, they're going to get run over."

The amount of shorting -- where traders sell borrowed stocks expecting to buy them back after prices fall -- jumped to 3.1 percent of the total shares listed on the New York Stock Exchange this month. That's the highest since at least 1931, according to Bespoke Investment Group LLC, a research firm in Mamaroneck, New York.

The wagers represent billions of dollars that could be invested in equities if short sellers close their positions. The bears also reassure fund managers who get skittish when few traders anticipate the possibility of a stock market decline.

"Ultimately you have to cover the short positions and that tends to create more of a buying frenzy," said Andy Engel, co- manager of the Leuthold Core Investment Fund, which has outperformed 99 percent of similar funds over the past five years.

Losses are mounting for traders speculating on a drop in stocks. So-called short interest on the NYSE rose to a record 11.8 billion shares as of May 15, 7 percent more than a month earlier, according to the world's biggest exchange.

"Anyone that did the theory, sell in May and go away, they're going to wish they never read that," Chicago-based Froehlich said. He expects the Dow average to climb 11 percent and reach 15,000 by Christmas.

Dow 15,000 on a short squeeze huh? I am hearing other targets like 1800 on the S&P. And there is talk of bears piling it on when bulls are pressing their bets based on merger mania in leveraged buyouts (LBOs) and banking on short squeezes.

The liquidity that is driving these LBOs can dry up at any time. I suspect it will be lights out at some point just as it was with Florida condos. Remember how people went from camping out overnight to get in on hot new condo developments to no bid almost overnight. We were all told that it would take much higher interest rates to kill housing. It didn't. The housing bubble popped on pure exhaustion.

I suspect the liquidity bubble fueling these stock buybacks and LBOs will die of exhaustion as well. Overnight (at a date unknown) there will be an attitude change and financing these deals will go from super easy to super hard just as we saw previously with subprime lending for housing.

As for short sales and the meaning thereof, the bulls are simply wrong. We talked about this at length last week on Buzz&Banter. In case you missed it, here is a repeat of Hussman's article called Spot the Pigeon.

A similar claim is that “there are a lot of shorts out there, and they're going to be forced to cover.”

Again, this is not supported by the data. Recent years have seen a proliferation of hedge funds, market neutral strategies, and merger arbitrage vehicles. All of these are based on matched long and short positions. These are not “speculative” or “naked” shorts, and in many cases are not even bets that the stocks sold short will decline (instead, the objective is to earn a difference in performance between the longs and the shorts, regardless of whether they both rise or fall in absolute terms). It is wrong to quote the current short interest as a bullish argument, as if the shorts are somehow compelled to cover here.

In today's Buzz, Jason Goepfert at SentimentTrader responded to this Mini-Minyan Mailbag:

"Regarding the record-breaking levels of short sales: My question stems from the fact, and from the remembrance of something (Prof. Succo) touched on awhile back, that the short sale figures can't really be relied upon due to traders who may be short, but vs. derivatives of some kind (in most cases being calls on a delta ratio)...

That being said my question is how much of the short sales out there do you believe to be part of a larger vol play and how much do you think is due to a plain vanilla short."

Minyan Michael

Reply from Jason Goepfert at SentimentTrader

Michael, this is a difficult question on which to even hazard a guess, since we don't know how many traders are using the options as a hedge versus speculation, and for those who do hedge, on what kind of ratio they're doing so.

But, that doesn't mean we can't take a guess, right? So here's my shot. From mid-April through mid-May, the NYSE reported 11.7 billion shares short, which was a change of +772 million from the previous month.

Over approximately the same period, there were 18 million call options bought to open on all the U.S. exchanges by large traders. By "large traders," I mean those that did transactions of 50 or more contracts at a time.

Assuming that every trader hedged those call options they bought, and they wanted to remain delta-neutral, and the average delta of the calls was 0.50, then they would need to short about 902 million shares.

There are a whole host of wild assumptions in that previous paragraph, but it resulted in these hedgers shorting 117% of the change in the NYSE short interest! That's obviously not possible, which means that some of our assumptions are off base.

If we assume that only half the traders were fully hedging those calls, then last month's activity would have explained about 60% of the change in short interest. Or, assuming that the traders did not remain exactly delta-neutral, or the average delta was lower, would also reduce the number of shares they had to short.

So without knowing a lot more detail, this is basically an impossible question to answer, but given the information we do have, it seems like derivative activity could possibly explain a big chunk of the monthly changes in short interest.

So there you have it. Thus there are three solid reasons why short interest is not what it seems: derivatives hedging, long/short funds, and arbs on convertible bonds. Once again mainstream media presents a distorted view of what is really happening and draws the wrong conclusions.

Stocks are not cheap and there is likely no short squeeze (in the broader sense). Instead we are in the midst of liquidity madness where it is more important to get deals done than it is for any deal to make sense.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/