Is Short Covering Really Propping Up the Markets?

I ran some screens over the weekend and thought I it would be interesting to take a look at the trading behavior of our universe (market cap > $200m, daily dollar volume > $4m) as it relates to short interest. There is a theory making rounds on the Street that short covering has been propping up the market to some extent and has kept this equity sell-off from being even worse. As hedge funds unwind positions (either voluntarily or involuntarily) they are forced to cover their short positions.

Following this line of reasoning, stocks with high short interest should have performed better as artificial buying would result from funds covering their short positions. Interestingly the actual data refutes this theory. When sorting the universe by last reported short interest, you can see that stocks with higher short interest have performed worse than stocks with lower short interest. Stocks with a short interest of 40+% of the float were down on average -35% over the past four weeks while stocks with a short interest of less than 5% are down -28.5%. This phenomenon is shown across the different short interest groupings with lower short interest correlated to less price decline.

I interpret this to mean that short covering has not been propping up the market to the extent that some think. I believe this suggests there is less risk of another leg down resulting from a decrease in short covering.

Also of note is that the average stock is down -30% over the past four weeks, which historically is a dramatic move for an entire year much less a four week period.

What are the trading implications? The clear contrarian move is to increase net long equity exposure however excellent timing is required to play mean reversion as the market can remain irrational longer than an investor can remain solvent.

Comments

[mekats:]

Data not terribly convincing. Stocks with shorts 40% of their float -35% while stocks with 5% of their float short -28.5%, only 1.5% below the average stock's decline is nothing short of torturing the data for precious little insight. The dominant influence was obviously market direction not the % of the float that was short.

2008 Oct 20 08:13 AM

[mcadoo3312:]

Thanks for doing the leg work with this. I understand where mekats is coming from, but ultimately, we do not know becuase there is no transparency with the hedge funds. Duh, right.

2008 Oct 20 08:31 AM

[John Lounsbury:]

Metkats, good comment.

Ben, a more important study would look at how the short volume has changed weekly for the high short volume stocks. If the average short volume group, now 40% short was 45% or 50% short a week ago, it could be argued that short covering has provided some support. If these changes were determined weekly for the past several weeks we might better understand if short selling has any correlation with market direction during this time period.

2008 Oct 20 09:41 AM

[ArcticFox:]

Short selling is way to manipulate the markets. We cannot short with our 401k, or our housing mortgage ... just another andvantage to the rich. Wall Street is a scam. Eliminating the short sell would help to remedy the corruption.

2008 Oct 20 01:38 PM

[Matt Blackman:]

A longer term study by Bespoke Investment Group found that rallies over the last five years have been led by the decile of stocks with the highest short interest. The double-edge is that they also led to the downside when the market turned down...
Takeaway, trade these stocks if we are in a bull market in rallies but its a tough game to try to play in bear markets...

2008 Oct 20 02:34 PM

[BerkeleyBob:]

Think your concluding sentence said it all: "The markets can remain irrational longer than the investor can remain solvent". About the only advantage an individual investor has is not being forced to cover a position or face redemption requests--in other words, it ain't a loss until it is sold.

2008 Oct 20 03:31 PM

[cynic69:]

Since the consumer is not only tapped out buy head over heals in debt and oil is still over $70 it looks to me like one would be better off joining the leauge of shorters. I don't think bottom is anywhere in sight.

2008 Oct 20 10:08 PM