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Barrons-Short Selling Falls Short as Predictor

Barrons-Short Selling Falls Short as Predictor

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09/09/2013

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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.

Even when focusing on just the last decade.Still. if the market does drop. . The theory behind this indicator used to be that such odd lots represent the smallest of individual investors. On the theory that specialists have information that the rest of us don't. even though they aren't really. I still could find no reliable pattern that could be the basis of a market prediction. Once again. Because of the narrowing of bid-asked spreads. Changes in the specialist short sale ratio. the markets have evolved in ways that undercut that theory. when market conditions were so different. Consider another short sale indicator known as the "specialist short sale ratio." Yet another short sale indicator is the odd lot short interest ratio. are most likely a reflection of little more than order imbalances. therefore. according to Prof. Specialists rarely take either naked long or naked short positions that are long-lasting. it's thought to be bearish if they increase their short selling activity relative to non-specialists. This doesn't mean that the bears will be wrong about the market's direction. it will have nothing to do with the recent jump in short interest. Ritter. Prof. however. 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. Furthermore. with high frequency traders largely serving the role they once filled. hope springs eternal. But this reasoning is suspect. it just means that. and many traders continue to think that must be another way of extracting a market indicator out of the short sale data. many more market orders than ever before are broken into smaller chunks and executed at slightly different prices. who more often than not are wrong in their bets. for example." This indicator reflects the proportion of total short sales on the NYSE made by specialists on the exchange. Some of those smaller chunks will be less than 100 shares and counted as odd lots. Ritter added. The bottom line? Short sale data doesn't carry the significance it used to. If there is. which reflects the number of short sales initiated in less than 100-share blocks. "specialists have become an endangered species in recent years. and instead use their trading to hedge their inventory in order to reduce risk.

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