by Investing Daily, Investing Daily
— this post authored by Linda McDonough
Article of the Week from Investing Daily
Lately, it seems that the bears can’t win, even on down days. I explain the forces driving this seeming anomaly. But more importantly, I’ll point you toward an investment system that takes the guesswork out of investing and makes money in bull and bear markets.
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Year to date the S&P 500 is up about 6%. This performance doesn’t look too shabby, but underneath the umbrella of this index, a multitude of stocks are declining. The advance-decline metrics for the market look quite soft.
The advance/decline line calculates the difference between the number of advancing stocks versus the number of declining stocks. While it’s interesting to look at it by itself, it’s most helpful to layer it over the index that it represents.
Since early August, the advance/decline line has been lagging the S&P 500. This means that fewer stocks are leading the market higher, which can be a bearish indicator.
One might think if more stocks are declining than rising, this would be a happy time for short sellers, those investors bearish on the market who profit when stocks fall.
And yet on weak days in the market, the only green popping up on my quote screens is in my “short” watch list. This screen is a list of stocks that I’m monitoring as possible bearish plays. I’ve noticed that those with the most significant short interest are often up on days that the market is down.
Index data compiled by Morgan Stanley and Thompson Reuters confirms this suspicion. The firms note that the outperformance of heavily shorted stocks versus the S&P 500 hit a four-year high in June. An index of the most-shorted stocks has surged since the end of March (see chart).
Short interest is a measure of how many shares are sold short on a stock. The interest is often represented as the percent of the stocks available shares are sold short. For example, if a stock has 100 million shares out and 20 million of those shares have been lent out to short sellers, the “short interest” is 20%.
Any stock with short interest higher than 10% starts to creep into the heavily shorted territory.
On one down day last week, heavily shorted stocks like Wayfair (NYSE: W), Mallinckrodt (NYSE: MNK), Teladoc (NYSE: TDOC) all rose. These stocks are up 36%-81% year to date.
I don’t know enough about the business models of Wayfair, Mallinckrodt or Teladoc to be bullish or bearish, but I do know the bears have done their homework on these names, and the group is up more than the rest of the market.
This doesn’t seem to make much sense, but it’s a pattern I’ve seen many times during the more than 25 years that I’ve spent researching short ideas. Hedge funds place most short bets. These funds split their portfolios between long and short investments. The expectation is that they will outperform in down markets and underperform in up markets, hence the term “hedge.”
This expectation can make weak days in the market the most stressful of all. After all, most of your long ideas are probably declining with the market. You’ve got to make up those losses with gains in your short bets.
If those stocks aren’t down significantly, the sweat starts to form on your brow.
Bull or Bear: Who Cares?
I see a few possible causes for the green pop in these heavily shorted stocks;
Short sellers are booking gains. This trade means they must “buy to cover” their short position. Once a heavily shorted stock turns green, other short sellers might panic and start to buy as well.
Portfolio managers need to rebalance their long and short exposure, especially when volatile days shift those exposures dramatically. As their long positions decline, they might need to trim their short positions as well, to keep ratios intact. This adjustment also leads to short covering and buyers of those heavily shorted stocks.
Quant funds, or those that are purely data-driven, might be including short interest in their data set. This inclusion could spur additional buying on down days.
Believe it or not, the best market for a short seller is a rational market that refuses to bid up stocks to ridiculous levels on shaky fundamentals. When the overall indices are acting well, investors are making money and have more funds to allocate to bullish and bearish funds.
