Saturday, April 28, 2007

Short Interest Ratio Increases: Bullish For The Market?

At Standard & Poor's Outlook website, the article, Stocks Headed Higher, discusses the fact that market sentiment indicators are showing an increase in "fear" versus "optimism". From a contrarian standpoint, this increase in fear as measured by the short interest ratio tends to be positive for future stock market returns.

"One way to gauge market sentiment is to watch the short-interest ratio on the New York Stock Exchange. First, the short-interest ratio is the number of shares sold short divided by average daily volume. This is often called the “days-to-cover ratio” because it tells — given the stock’s average trading volume — how many days it will take short sellers to cover their positions. Short sellers are, of course, betting on a price decline.

Since 1994, the NYSE short-interest ratio has oscillated between 3.7 and 7.5. The higher the ratio, the more investors are betting on a market decline. The lower the number, the more investors are looking for a rise in stock prices. The average ratio over this period has been 5.4. We view readings of 6 and above as bullish and readings of 4.6 and below as bearish. The current NYSE short-interest ratio is 7.4, or right near the top of the range since 1994 and just below the all time high of 7.5 in October 1996."
The article also discuss futures trading and the three types of futures players:
"...the commercial hedgers (smart money), large speculators (dumb money), and small speculators (dumber money). If we look at the current posture in the S&P 500 e-mini contract, commercial hedgers are net long the stock market, while large speculators are net short the market by a very large margin. The same situation can also be seen in the Russell 2000 e-mini contract. An e-mini contract is a portion of a standard futures contract. It trades in a highly liquid market and is more affordable for investors.

Small investors and large speculators are betting on lower stock prices. We will place a wager on the smart money; they are betting on further upside."
Given the recent positive moves higher by some of the higher quality large cap stocks, some short covering may be providing a tailwind to this market.


Stocks Headed Higher
The Outlook
By: Sam Stovall, Chief Investment Strategist
April 27, 2007

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