Short Interest: What Does It Mean For This Market Cycle?

From time to time I have noted the high level of market short interest.

Short interest is the total number of shares of a particular stock that investors have sold short in anticipation of a decline in the share price and have not yet repurchased the shares.

Short interest is often considered an indicator of pessimism in the market and a sign that prices will decline. From a contrarian perspective, some view short interest as a positive sign, pointing out that short sales have to be covered, and that the need to repurchase the shares sold short can increased demand for a particular stock potentially forcing the stock price to move higher.

In today's Ahead of the Tape column in the Wall Street Journal, the column noted:

So-called contrarians typically see such bearishness as a reason to buy. The idea is that when investors are down on stocks, expectations are so low that the slightest inkling of good news can send prices higher. In contrast, when investors get too bullish, stocks get priced for perfection, and when perfection doesn't come, stocks decline.

But with hedge funds cutting a much bigger swath in the market, today's high level of short interest doesn't represent the bearishness that it did in the past. Many hedge funds engage in a strategy of offsetting the purchase of shares in one company by shorting another, betting that it will perform worse than the stock of the company that they own. Then there is the booming deals market, which drives merger arbitrage, where investors buy shares of companies set to be acquired and short the acquirers.

I agree with the article that the increased M & A activity is contributing to the higher level of short interest. Another interesting indicator is the put/call ratio. There is an interesting article at this link that looks at the put/call ratio. As detailed in a few of the comments to the article, it is important to look at the direction of an indicator and not just the absolute level.

In the end, an important point to be drawn from this is one should not look at a single variable when making investment decisions.

Source:

Short Story: Bearish Bets Lose Bullish Bias ($)
Ahead of The Tape
The Wall Street Journal
By: Justin Lahart
May 30, 2007
http://online.wsj.com/article/SB118048148598217838.html?mod=todays_us_money_and_investing