Barrons-Short Selling Falls Short as Market Predictor

Short-Selling Falls Short as Market Predictor

By MARK HULBERT | MORE ARTICLES BY AUTHOR

More than a few eyebrows were raised last week when David Rosenberg, chief economist and strategist at
Gluskin Sheff, a Toronto-based wealth management firm, drew attention to the recent big jump in short
interest.

Rosenberg, a former Merrill Lynch investment strategist and prominent market bear, wrote that "some folks
are beginning to notice that the wheels are starting to fall off the tracks… because short interest on the
NYSE rose a hefty 2.8% in the first half of February."

I'm not so sure that short interest, which tracks the volume of stocks shares that are sold short and not yet
covered, has the significance that Rosenberg attributes to it. (Traders sell shares short when they think that
they will fall in value. Those traders are later obligated to cover the position by buying those shares back,
hopefully at a lower price.)

Indeed, I'm not sure that the short interest even measures what he thinks it does.

Traders need to be careful before basing any of their trading strategies on short interest. In fact, it could well
be that short interest has little value these days in predicting market turns.

To put a given short interest number into historical context, analysts typically divide it by average trading
volume, creating what's known as a short-interest ratio. One way of interpreting this ratio is that it represents
the number of days of trading that are needed simply to cover all the shares that are outstanding.

Even so, it's not clear that different periods' short interest ratios are comparable in any meaningful way,
according to Jay Ritter, a finance professor at the University of Florida. One complicating factor, he pointed
out, is the growth in recent years of high-frequency trading.

There have been some days in recent years, for example, in which more than 40% of the trading volume
represented the initiation of a short sale—the vast majority of which came from high frequency traders. This
has caused short interest to be higher in recent years than it otherwise would have been.

Furthermore, high frequency has stripped from short selling the connotation of the negative long-term bet
that the activity had in previous decades. After all, most of the short sales initiated these days are covered—
that is, the shares are purchased by the short seller—within minutes.

Another complicating factor, according to Prof. Ritter, is the greater ease with which small-cap stocks are
able to be sold short. It used to be that it was difficult, if not impossible, for a prospective short seller to
borrow such shares in order to sell them short. This is much less true today, and because of this, total short
interest has grown markedly in recent years—for reasons having much to do with a particular company's
stock but having little or nothing to do with the overall market.

Because of these and other factors, Prof. Ritter said that he believes there is "no reliable relation" between
the level of short interest and the stock market's subsequent behavior.
Still, hope springs eternal, and many traders continue to think that must be another way of extracting a
market indicator out of the short sale data.

If there is, I haven't been able to find it—despite searching closely through a database of short interest data
extending all the way back to 1931. Even when focusing on just the last decade, when market conditions
were so different, I still could find no reliable pattern that could be the basis of a market prediction.

Consider another short sale indicator known as the "specialist short sale ratio." This indicator reflects the
proportion of total short sales on the NYSE made by specialists on the exchange. On the theory that
specialists have information that the rest of us don't, it's thought to be bearish if they increase their short
selling activity relative to non-specialists.

But this reasoning is suspect, according to Prof. Ritter. Specialists rarely take either naked long or naked
short positions that are long-lasting, and instead use their trading to hedge their inventory in order to reduce
risk. Changes in the specialist short sale ratio, therefore, are most likely a reflection of little more than order
imbalances. Furthermore, Prof. Ritter added, "specialists have become an endangered species in recent
years, with high frequency traders largely serving the role they once filled."

Yet another short sale indicator is the odd lot short interest ratio, which reflects the number of short sales
initiated in less than 100-share blocks. The theory behind this indicator used to be that such odd lots
represent the smallest of individual investors, who more often than not are wrong in their bets.

Once again, however, the markets have evolved in ways that undercut that theory. Because of the narrowing
of bid-asked spreads, for example, many more market orders than ever before are broken into smaller
chunks and executed at slightly different prices. Some of those smaller chunks will be less than 100 shares
and counted as odd lots, even though they aren't really.

The bottom line? Short sale data doesn't carry the significance it used to. This doesn't mean that the bears
will be wrong about the market's direction; it just means that, if the market does drop, it will have nothing to
do with the recent jump in short interest.