May Option Advisor Commentary

              

The following is a reprint of the market commentary from the May edition of the Option Advisor, published on April 17. Prices and the chart are as of the close on April 17. For more information or to subscribe to the Option Advisor, click here.

In a fascinating column entitled "What's Behind The Bad-News Rally?" in the April 21, 2008 issue of Barron's, Michael Santoli leads with the following:

"Let's imagine a trader who got it exactly right coming into this year, nailed the whole macro picture and identified each of the closetful of "other shoes" that have dropped on the market: the continued erosion in housing, the stubborn dysfunction in credit markets, the broad realization that a U.S. recession is likely, the softening job market, the desperate-seeming Fed officials with not enough fingers for all the sprung leaks. And, to capitalize on this fretful scenario, say this trader shorted the S&P 500 on Dec. 31. To date, having gotten every relevant headline correct, his or her profit is all of 5% ... After last week's 4% gain on mostly lousy, but not as lousy as feared, corporate news, why is the market not down a bunch more, given the news and the evident risks?"

Michael then goes on to cite some plausible explanations, including the fact that an unprecedented amount of stock had been taken off the market ahead of the market peak, and that valuations in the latest bull market phase had never gotten unrealistic - in fact, earnings multiples had declined throughout.

I wrote Michael a note after I read his piece, part of which I reproduce below.

"I can't help but believe that the steady growth in the short trade that corresponds to the spectacular growth in hedge fund assets under management since the bear market bottom in 2002 has got to be a major factor.

Increasing pressure from the short trade helped keep stock valuations from getting out of hand during the bull phase, and you have to believe that short covering/put liquidation has been a contributing factor to the event-related pops in recent weeks, most recently on earnings announcements. I've always felt that the most immediate gauge of the size of the short trade is the reaction to 'neutral' earnings news, and per Kopin's column this week, the reaction has thus far been clearly positive.

I also find it interesting that Fidelity started up its '130/30 Large-Cap Fund' (FOTTX) with an inception date of 3/31/08. Not only is this a pretty strong indication of the 'mainstreaming' of short selling, but it's difficult given the timing to believe that a major bear run is now in the cards. I'll note for what it's worth that the crude oil exchange-traded fund (USO) was launched in the second quarter of 2006 ahead of a pullback in oil prices that approached 40% before the bottom in early 2007."

Aggregate short interest on the New York Stock Exchange reached 4 billion shares in 1998 and 8 billion shares by 2002. And now it has again doubled to 16 billion shares, a period that was also accompanied by a big surge in aggregate put open interest to ongoing record levels.

The activities of the "new shorts" (and by this I mean an institutionalized, mainstream short-selling trade that is practiced by well capitalized hedge funds and traditional money managers) have been of great interest to me. It is by no means the case that you want to blindly "fade" their big positions by taking a contrarian bullish stance, as there have been numerous examples over the past year of heavily shorted stocks whose share prices have been (and continue to be) savaged by the market, due in no small part to the willingness of these deep-pocketed shorts to "double down" and add to their positions when they are working.

In addition, the new shorts are much less prone than they have been in years past to flee when positions move against them, so the short-covering rallies fueled by panicked short liquidation have become somewhat scarcer. That said, one need not look further than today's action to find an example of a short-covering panic, as shares of Ford - with a short interest of over 270 million shares and put open interest of 1.3 million contracts - surged by as much as 16% on a positive earnings surprise.

Last month, Joe Sunderman discussed in these pages the unprecedented bearishness reflected this year in the slant of the financial media, as evidenced by the astounding number of bearish magazine covers. He bluntly stated that "We have never seen such an onslaught of negative cover stories in all our years of tracking the market." I believe this "mega-bearish" media tilt reflects the likelihood that the bad economic news has already been reflected in this market, and that the upside potential from a combination of short covering and the movement of some of the now huge store of sideline money back into the market comfortably exceeds the downside risk.

It is also interesting to note the fact that the CBOE Volatility Index (VIX) has recently moved below its 32-week and 40-week moving averages after over a year of trading above these levels. In other words, just as the headlines are beginning to scream "fear," professional options traders are beginning to be a lot less fearful. And I'll go with the opinions of the professional options trading community over those of the headline writers any day of the week.

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