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Short Interest Data Suggests Considerable Upside Potential

The long-term bullish outlook for equities looks promising, thanks to hedge funds

by 10/4/2012 12:43:53 PM
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If you are looking for a bullet point to be bullish longer-term, I think the action in short interest might interest you. Although I've noted some concerns recently, the big picture shows that this bull market is alive and well for longer-term investors.

Our theory here at Schaeffer's is when hedge funds are aggressively buying stocks, they are probably covering their short hedges and, in turn, accumulating equities. In other words, lower trending, total short interest is bullish. The flipside to this occurs when hedge funds are accumulating shorts, and possibly building up their bearish bets. Thus, this can act as a headwind for the market.

As you can see in the chart below, the last time short interest on all the optionable stocks (about 2,600 in our database) got this high and rolled over, it sparked a 30% rally in the S&P 500 Index (SPX), as well as a 40% rally in small caps. Also, it's pretty clear that the higher-trending short interest usually isn't very bullish.

Chart of Short Interest on All Optionable Stocks Versus the S&P 500 Index since January 2011

The data that just came out did move higher, to the tune of 1.25%. But what's amazing is that we've had a big rally since early June, yet the shorts have barely covered. This shows that hedge funds are drastically underexposed to the market -- even after the strong gains! (What's more, some recent data from other sources have come to similar conclusions.) Hedge funds missed out on the summer rally and have a good deal of money that could still be put to work here. Our work with short interest only helps to confirm this thesis. My colleague Joe Bell and I discussed why hedge funds could push the market higher the rest of this year, as they play catch-up ... and I still feel this way.

Say what you want about the economy and the upcoming election -- the reality is, there could be a huge chase for performance to end this year. Just imagine how much higher the equity markets could move if the shorts continue to cover and move much lower. Here's a longer-term chart of total short interest:

Chart of Short Interest on All Optionable Stocks Versus the S&P 500 Index since January 2008

Incredibly, short interest is still near the top end of its range the past few years, and is actually close to the March 2009 generational lows! I'll keep watching this one, but as this market continues moving higher, I fully expect the shorts to cover, the hedge funds to accumulate equities, and overall equity prices to advance across the board.

Here are some additional articles of interest:

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