Fear of Losing More Sparks Short-Seller Stampede

Looming SPX and RUT century marks could be the catalyst for sellers to finally emerge

Senior Vice President of Research
Jan 22, 2018 at 8:48 AM
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"On Wednesday, the RSI moved above 80 for the first time since Feb. 21, 2017. Looking back at data for the SPDR S&P 500 ETF (SPY - 277.92) since 1993, this has happened only eight times. Although it is a limited sample size, when RSI reaches this level, the SPY has historically underperformed over one-week and one-month times. The other big takeaway is that the SPY has outperformed over three-month, six-month, and 12-month time frames after RSI reaches 80 or higher."
    -- Monday Morning Outlook, January 15, 2018

Despite reaching an extreme short-term overbought condition two weeks ago, the SPDR S&P 500 ETF (SPY - 280.41) defied historical expectations of an expected 1% pullback, on average, and instead rallied 1.8%. As we saw last week, overbought oscillators lose some effectiveness in a trending market -- and with the SPY only experiencing one close below its 20-day moving average since late August, the prevailing trend overpowered the short-term sell signal.

SPY chart with 20-day

"In the most recent short interest report, there was finally a tick lower, after a relentless surge in recent reports. This decline in short interest is occurring from around the same level as what we saw prior to the November 2016 elections. I cannot say for certain whether the shorts will continue to cover -- but it does appear that many are playing a losing game, which increases the probability of short covering. Considering how the SPX behaved as it fought headwinds from a build in short interest, just think of its capabilities if the short-selling headwind turns into a short-covering tailwind."
    -- Monday Morning Outlook, October 16, 2017

"Some market observers have dubbed this phenomenon Fear of Missing Out, as stock market records fall on an almost weekly basis. Others refer to a 'melt-up' market, where the prevailing mood is shifting to greed from fear and investors stampede in without worrying much about valuation or fundamentals.”
   -- The Wall Street Journal (subscription required), January 17, 2018

What might be at work with respect to the recent momentum in the market? How about short covering? I've mentioned in several commentaries since at least mid-October that one of the bigger risks to the bear case is the huge short interest on components of several major equity benchmarks and related exchange-traded funds (ETFs), such as the S&P 500 Index (SPX - 2,810.30), PowerShares QQQ Trust (QQQ - 166.34) and Russell 2000 Index (RUT - 1,597.63). And it's not only the large relative short interest on these components, but the fact that the short interest build occurred within the context of many of the underlying stocks advancing -- implying the shorts were in losing positions. 

A fresh look at current short interest suggests that the shorts could be in panic mode, or are being forced to liquidate losing positions. After the election in 2016, we witnessed how short covering could drive stocks, and it appears we are seeing this again in recent weeks.

The series of charts immediately below indicate that the shorts are finally in eye-opening covering mode. And the good news for bulls is that, as of the last report, total short interest on components of the SPX, QQQ, and RUT still has a ways to go before hitting the lows from early last year.

While "FOMO" (fear of missing out) is an acronym you may see and hear in the media in the coming days and weeks to explain the rally, understand that "fear of losing more" could also be at work as underwater shorts bail on losing positions. This is precisely why we created a screen months ago looking for highly shorted stocks in which the short interest build was concurrent with an advance in the equity. Such names as Michael Kors (KORS), Square (SQ), Kohl’s (KSS), Foot Locker (FL), and Cboe Global Markets (CBOE) are just some of the names on this list. 

SPX short interest

QQQ short interest

RUT short interest

As we enter this week’s trading, keep in mind that the SPX and RUT are both near round-number levels at 2,800 and 1,600, respectively. More times than not, these century levels can mark brief (or lengthy) hesitation areas within established uptrends. Since the SPX took 2,500, the century-mark levels have acted more as brief, rather than lengthy, hesitation areas. 

spx around century marks

At risk of again calling for the current momentum we are seeing weaken in the days ahead, I’d be remiss to fail to mention that the century-mark phenomenon is next up on the technical list as a reason to expect sellers to finally emerge. Stay tuned (and tell everyone that you heard it here first, if this plays out).

In the meantime, stay long those equities that are highly shorted and displaying favorable price action. Try to concentrate your holdings on those equities where you see evidence that shorts are in covering mode. 

While short-covering makes a strong bull case for the days and weeks ahead, other sentiment indicators are showing optimism -- such as the ratio of equity call buying to put buying, in addition to various surveys, such as Investors Intelligence and the National Association of Active Investment Managers (NAAIM). However, optimism in a bull market like this is expected, and is less meaningful in its implications relative to optimism when there is evidence that the technical backdrop is deteriorating. Nonetheless, if the optimism/unwinding of pessimism is concerning you, continue to use call options to play equities with perceived upside as a way to both manage risk and participate in the underlying uptrend. 

If you buy calls, stay in tune with how equity options are priced for different expiration periods, since earnings season is here. Options with expirations that occur simultaneously with or just after an earnings report will be priced higher from an implied volatility perspective than options expiring before or well after the underlying equity‘s earnings report.

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