Much of the fuel for the 50% rally in the S&P 500 has come from short covering. The general skepticism surrounding the recovery has actually resulted in price gains. But as the rally gets long in the tooth we could be seeing signs that short covering will have a much smaller impact.
The huge declines in short interest are a sign of capitulation in short selling. The bears have been truly slaughtered during this bull run. The change in short interest should be viewed as a contrarian indicator at this juncture. This is also a clear sign of a major change in investor sentiment.
In addition to major changes in short interest, this weeks AAII poll displayed a remarkably bullish reading of 51%. We haven't seen a reading this high since May 2008 just after the government intervened in Bear Stearns and the market rallied. At the time, everyone was bullish and was declaring that a recession was off the table and a second half recovery was a near certainty. Of course, when everyone is on the same side of the boat, it's wise to either move to the other side or simply jump off. The bullish side of the trade, in terms of sentiment is incredibly crowded. Positive sentiment can remain high for extended periods of time and can be a major driver in higher prices, however, these environments make for very poor risk/reward scenarios. If any element of doubt or uncertainty creeps into the market we could easily see a sharp and dramatic correction.
RUNNING OUT OF FUEL FOR THE RALLY?
Following July's leg higher, it seems that traders on the short side have cut and run. As shown in the chart below, the average stock in the S&P 500 had 4.97% of its float sold short as of the end of July. This is the lowest level since January 30th, and marks a decline of 17% from the peak levels in July 2008. Bears will cite this number as proof that investors are crowded on the long side. While bulls would probably prefer to see higher levels of short interest, they are likely to note that short interest still remains high from a longer-term perspective.
WAS IT JUST A SHORT COVERING RALLY?
The light volume, poor breadth and quick surge in the market over the last three days has a lot of people calling this nothing more than a short covering rally. I went back and looked at the list of the S&P 500 stocks with the highest short interest to see how they've performed over the last three days. The results are pretty good. The average stock on the list has returned 10.5% over the last three days with none of them turning in a negative return. The S&P is up 6% over the same period. The Nasdaq 100 is up 5% and the Russell 2000 is up 7% over the same period which would imply that beta has had little to do with the overall return of these names and that this has indeed been a short covering rally.