S&P Short Interest: Red Flags for Both Bulls and Bears
The current upward trend in short interest may be alarming to bulls, but the absolute level of short interest should concern bears
Todd Salamone
Senior Vice President of Research
It was another volatile week for equities, with an early-week sell-off back near the August lows followed by a late-week recovery. Many were looking for a re-test of the lows, and it occurred rather quickly.
$VIX pop this week after the move below 20.37 ('15 half closing high). Decline followed move above 23.90 (double '15 closing low) $SPX
— Todd Salamone (@toddsalamone) September 25, 2015
The CBOE Volatility Index (VIX - 20.94) popped back above 23.90, double its 2015 closing low, just as it did the prior week. The closing high last week was 27.63, just above 26.64, which is half the intraday high for August. Last week's pop was quickly followed by a move back below 23.90, even after a brief pop back above this level immediately following Friday's employment number, which came in far below expectations.
By Friday, the VIX was already trading down to a potential area of support that we have identified in previous commentaries, between 19.20 and 20.37 -- 19.20 is the site of the 2014 close, and 20.37 represents one-half the 2015 closing high for August. We continue to think that one potential sign of a market bottom being in place is the VIX retreating back below the 19.20-20.37 zone, as it is quite evident that a floor has been building in this vicinity since mid-September.
That said, an encouraging sign is that despite the S&P 500 Index (SPX - 1,951.36) dropping to a Tuesday low of 1,872, just 5 points above the August closing low, the VIX intraday high last week was only 28.33, or 47% below August's VIX intraday high of 53.29. This divergence is something for both bulls and bears to note -- especially in the context of the bear market bottoming phase in early 2009, when the SPX retreated to the October 2008 low, but the VIX high was 40% below the October 2008 VIX peak.
Round millennium levels coming into play as support (U.S, China, Europe): $DJIA 16K $FTSE 100 6K $SHANGHAI 3K
The simultaneous pullback to round numbers on key equity benchmarks, here in the U.S. and around the world, got on our radar about the middle of last week. Specifically, major indexes in Europe and China pulled back to round-number millennium levels, just as the Dow Jones Industrial Average (DJIA - 16,472.37) was again probing the 16,000 level. In fact, on Monday and Tuesday, the DJIA dipped below 16,000 on an intraday basis, but closed above this level on both days. And during the Friday morning employment-number rout, the DJIA low occurred in the first half-hour of trading, at 16,013. So, again, paying attention to round numbers as potential pivot areas or hesitation points is proving valuable in this "turn on a dime" market.
Not to be forgotten, after last week's dust settled, the SPX managed to close the week above the round 1,900 century mark, and back above 1,917, which is roughly 10% below its 2015 high. Tech stocks also got into the round-number game. The Nasdaq Composite's (COMP - 4,707.77) low last week occurred around the 4,500 half-millennium mark, site of the August closing low, too. Moreover, the Friday morning low on the PowerShares QQQ Trust (QQQ - 104.01) was just above the 100 century mark.
Having said that, the Russell 2000 Index (RUT - 1,114.12) comes into the week fighting to sustain a move back above the 1,100 century mark, which marked a high in Thursday morning's trading. Meanwhile, the S&P MidCap 400 Index (MID - 1,386.08) is still trading significantly below the round 1,400 century level, which served as support in late 2014, but acted as resistance late last week and in early 2014.
"… on Twitter last week, I observed how remarkably alike the SPDR S&P 500 ETF Trust (SPY - 192.85) price action is to 2011, when the market last corrected, bottoming in mid-October of that year ... We continue to see strong potential for increased volatility into October ... Continue to maintain exposure to explosive moves in both directions, as the jury is still out as to whether we are building a base after a correction, or in a bear market."
-- Monday Morning Outlook, September 28, 2015
I have spent a lot of time recently discussing the SPX's technical backdrop, which ranges due to the increased probability of a prolonged weak market following two consecutive monthly closes below its 20-month moving average, but also the possibility of a repeat of its 2011 technical pattern -- when a long rectangular formation preceded a correction into the fall, before a powerful rally commenced over the next several months. The 2015 comparison to 2011 was discussed at length last week.
Short interest on $SPX component names spikes to highest level since financial crisis - a coincidental headwind pic.twitter.com/Tq05tKDL3V
"'The persistency of negative momentum will induce hedge funds to turn even shorter equities,' he said, adding to the selling pressure over the market."
-- The Wall Street Journal, September 29, 2015, quoting Nikolaos Panigirtzoglou, J.P. Morgan analyst
During the past few weeks, I have also observed the extremes in negative sentiment -- on par with sentiment conditions that have occurred at major market bottoms. Along with these discussions, the caveat has been that contrarian implications of these sentiment readings are downgraded when the technical backdrop has weakened, which has been the case.
If the technical environment remains weak, the shorts are less apt to be squeezed, and more apt to press their bets, generating more market headwinds. Nonetheless, increased shorting represents future buying power, which is why I advise remaining flexible as to your exposure, especially if you are short-term oriented.
As I mentioned on Twitter last week, short interest on SPX component names spiked in the reporting period from Sept. 1 to Sept. 15. It is now at the highest levels that we have seen since the financial crisis. Rather, it is the trend in short interest's direction that should concern the bulls the most. Should this trend persist, the shorts will press their bets on rallies, therefore capping advances. But the absolute level of short interest should also alarm the bears. If the Sept. 15 data point proves to be a peak, a prolonged short-covering rally could quickly turn the tide in the bulls' favor, as we saw in the fourth quarter of 2011 -- hence, our advice to maintain exposure to both the long and short sides of the market.
So, in addition to the VIX moving back below the floor discussed at the beginning of this commentary, and the SPX moving back above the 2,000 level as discussed in previous commentaries, another potential confirmation that a bottom is in would be a roll-over in the SPX's component short interest. It would signal that headwinds from continued shorting activity have dissipated, with continued short covering providing a tailwind.
SPX Component Short Interest -- five-year high, up 21% YTD
But short interest data is reported every two weeks, and is on a two-week delay. So we turn to the behavior of options speculators for daily clues on sentiment shifts. Per the chart below, equity option buyers are also at a multi-year pessimistic extreme. The build-up in pessimism among equity option speculators is confirmed by higher lows in the put/call volume ratio and higher highs. So, like 2009, one thing to look for with respect to this ratio confirming that a bottom is in (or near) would be a lower high being followed by a lower low. This has not occurred, but it is something that we'll continue to follow closely as we look for clues as to which way the SPX's next big move will be.
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