Market Direction and Stock Trends

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This is what should really worry you about stocks
By Mark Hulbert | July 21, 2017

Short-sellers often get it right — and now they’re more bearish

Here’s something the bulls should be worried about, but are not: The volume of short selling, which has been increasing each month since last December.

I’m focusing on this as a follow-up to several previous columns that had a happier conclusion: Issues that the bulls erroneously think are worrisome — such as the VIX’s VIX, +2.92% low level and the flattening yield curve.

But not all the data point to a bullish conclusion. And when it comes to the short interest data, the bulls are kidding themselves in thinking that the volume of short selling is a contrarian indicator—with lots of shorting being a bullish omen, and vice versa.

But this contrarian interpretation is wrong, according to a study that appeared recently in the Journal of Financial Economics, a respected academic journal. That study found that short sellers on balance are right more than they’re wrong, and that in turn means it’s worrisome that the volume of short selling has risen so steadily this year.

On the face of it, of course, it seems unlikely that any group of investors should on average be able to beat the market. After all, as everyone knows, stock picking in general is a losing game. Why should those who bet stocks will go lower do better than those who bet they’ll go higher?

The answer, according to Matthew Ringgenberg, is that it’s much harder to sell a stock short than it is to buy it. Ringgenberg is a professor of finance at the University of Utah and one of this new study’s authors. In an interview, he pointed out that the markets place a number of hurdles in front of the short seller that don’t exist for investors on long side: It’s costly to borrow shares in order to sell them short, for example, and it’s not always easy to find borrowable shares in the first place. Short selling is especially risky, since the potential loss is infinite.

These obstacles keep away all but the most committed of investors, which is why short sellers are more likely to be right than those who purchase stocks.

In this new study, Professor Ringgenberg and his colleagues constructed a short-selling index that reflects whether the total volume of short selling is above or below a moving average. They then used the index to forecast the stock market’s return over the subsequent 12 months, with above-average short selling being a bearish sign and vice versa. They found that their model had a better track record than any of 14 other market-timing indicators that previous research had identified as showing promise.

Their model certainly worked well over the last year. In June 2016 I reported on this new research and concluded that “U.S. stocks will be higher in 12 months — despite Brexit.” The S&P 500 SPX, -0.32% today is more than 20% higher.

Unfortunately for the bulls, Professor Ringgenberg’s model is less bullish today. The chart below tells the story.



Consider first the blue line in the chart, which shows Ringgenberg’s index steadily rising over the past six months. That wouldn’t in and of itself be an immediate cause for alarm, since this recent increase came from extremely low (and bullish) levels and the index remains in bullish territory.

But now consider the green line in the chart, which is the result of Ringgenberg slicing and dicing the short-interest data more finely to identify the underlying trend. Notice that it is well into bearish territory.

Taken together, Professor Ringgenberg told me, these two lines suggest the stock market is in the neutral zone and that it may well be at or close to an “inflection point.”

http://www.marketwatch.com/story/this-is-what-should-really-worry-you-about-stocks-2017-07-21

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