Invesco QQQ Trust Series 1 (QQQ)

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A Popular Stock Signal Falls Short
By MARK HULBERT

Changes in the marketplace make the short-interest ratio a less reliable predictor of future stock-price activity.


A FAVORITE INDICATOR OF contrarian investors has turned green for the stock market right now.

But, as is often the case, appearances can be deceiving. In this case, the indicator just ain't what it used to be.

I'm referring to the short-interest ratio, which is based on the total number of shares sold short in anticipation of lower prices. The specific ratio is calculated by dividing this total by average recent daily stock exchange volume. The result can be thought of as the number of average-volume days it would take for the short sellers to cover all their outstanding shorts.

Higher short-interest ratios therefore mean that the bearish sentiment has already built into the market, which is a good sign from a contrarian point of view. And that's why some contrarians are feeling pretty good about the stock market:

The short-interest ratio for the New York Stock Exchange recently has been at or close to all-time highs of close to 10, a level more than double its long-term average level.

Unfortunately for the bulls, however, there is less here than meets the eye.

For starters, the past few months haven't been the only time that the short-interest ratio has been particularly high. In fact, far more often than not this decade, it has been above average. This upwards secular trend suggests that current short-interest ratio levels do not have the bullish significance that the contrarians are assuming.

Researchers attribute this upward trend in the short-interest to several factors. One is the increasing proportion of shares on the NYSE that reflect asset classes other than the U.S. equity market -- such as bond-oriented closed-end funds, country funds, and American Depository Receipts (ADRs). Ned Davis, of Ned Davis Research, a quantitative research firm that caters to institutional investors, estimates that half of NYSE-listed issues now fall into these non-equity categories.

Needless to say, short selling of those issues carries no contrarian significance for the U.S. stock market.

Another factor contributing to the upward secular trend in the short-interest ratio is the growth of the hedge fund industry. Hedge fund managers are particularly predisposed to actively engage in various complex hedging strategies. In many cases, those hedges do not mean that those managers are outright bearish, either on the particular stocks being shorted or on the market as a whole.

Instead, those hedges often are designed to exploit various anomalies in the relative prices of two or more securities. They are designed to make money regardless of whether the overall market goes up or down. It would be a mistake for contrarians to place much bullish significance on the shorts that are part of these hedges.

A related factor has accelerated this secular uptrend in the short-interest ratio over just the last year: In the summer of 2007, securities regulators removed the so-called uptick rule. That rule had prevented investors from selling a stock short unless its most recent price was higher than the previously traded price. The presence of that rule had forced hedge fund managers and others to go elsewhere to sell shares short, such as the over-the-counter market and those foreign exchanges where many U.S. shares are otherwise listed.

With the removal of the uptick rule, however, hedgers have been able to use the NYSE for all their short sales of NYSE-listed issues.

How can we eliminate from the short-interest ratio the influence of these various factors? It is relatively easy, though nevertheless quite tedious, to eliminate the role played by the increasing proportion of NYSE volume coming from non-equity securities. It is far more difficult, if not impossible, to eliminate the role played by the increasing prevalence of hedging strategies, since the stock exchange data on short selling activities don't, and can't, differentiate between outright shorts and shorts that are part of such strategies.

Even so, however, it is clear that the true short-interest ratio would be a lot lower than suggested by the raw data.

Ned Davis Research, for example, calculates that the NYSE short-interest ratio would currently stand at 4.18 if the indicator were to be based on just U.S. common stocks that are listed on that exchange.

Even though this is still inflated by short-selling that represents various hedging strategies, it is less than half what the ratio would be if all NYSE-listed issues were included.

Another indication of how inflated is the raw short-interest ratio comes from focusing on just those shares that are included in the S&P 500 index. According to Ned Davis Research, that ratio would currently stand at 3.0, even lower than the comparable ratio for the U.S. common stocks that are NYSE-listed.

Ned Davis Research classifies these adjusted levels of the short-interest ratio as merely neutral. That's because they calculate that the stock market in the past has, overall, produced merely average returns when the short-interest ratios were in the same range as where they stand currently.

Whether you are encouraged by this conclusion depends on whether you are inclined to see the glass as half full or half empty. On the one hand, the short-interest data, properly interpreted, do not provide support for those who believe that stocks are about to enter into a major bear market.

But, on the other hand, those data also do not provide the bullish support that some contrarians are otherwise assuming.