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Short Interest Still Says this Rally Won't Stop

News from the Fed simply fanned the flames of an already bullish fire

by 9/14/2012 10:00:15 AM
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For your sake, I hope you're not one of the perma-bears who are kicking and screaming that the market is "rigged," and that the Fed is the only reason this market is going higher. This couldn't be more wrong. Clear back in mid-June, I pointed out several reasons to expect a surprise summer rally.

It all comes down to expectations. The reality is, when you are crucified by the masses for being bullish in a bull market, I can't stress how powerful that is. If you've followed what we've been saying here at Schaeffer's Investment Research -- or what I've been saying on Twitter -- then you know this rally should be anything but a surprise. Taking it a step further -- when I'm called some choice names for being a bull on Twitter -- well, that right there says to stay bullish.

At Schaeffer's, we've had a year-end S&P 500 Index (SPX) target of 1,525. We gave that target on the first day of the year. Again, when I explained why we were bullish to those that would listen, I actually got the feeling they felt sorry for me. Well, in a bull market, that is exactly what you want to see. Now did the Fed cause the recent strength? Probably, but is that the reason we're at multi-year highs? I simply don't believe it.

If all you followed were the technicals, then back in July they were screaming that we were due for new highs, and that's exactly what has happened. Don't pay attention to the headline noise -- and yes, the Fed and QE3 is noise to me. All that matters is price action and sentiment. When you combine those two very powerful indicators, you can let everyone else worry about "why" this market is going higher and simply profit from it.

The next question is, now we've hit new highs, what drives us higher? To me, the action in short interest is fascinating, and suggests this rally could still have legs to make a potentially huge move. This indicator is and has been one of my favorite reasons to be bullish. I've been saying for months now that when short interest goes lower, it is very bullish. Our theory is that higher short interest is a headwind for equities, and once it rolls over, it can be quite bullish. According to our database of 2,600 stocks, short interest was flat in the recent period. However, it's now down 4.4% since its mid June peak. Remember mid-June? Not a bad time to be bullish.

Chart of SPX Versus Short Interest since January 2011

Take a closer look at the chart above. Higher short interest tends to be trouble for the market, while lower short interest suggests that bulls take charge. What is very exciting if you are a bull is that this ratio has a ways to go lower to get to where it ended earlier this year. In other words, should this market keep going higher, the shorts will be forced to cover and potentially push us much, much higher.

For a quick history lesson, the last time short interest was this high and rolled over, it sparked a 30% rally in the SPX and more than 40% rise in the Russell 2000 Index (RUT). Could we be looking at another rally like that now? I wouldn't bet against it.

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