Short-Covering Boosting the Broad Market

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by: Alan Brochstein, CFA

File this in the "silver lining" category, as I now have a new data field for screening: Short-interest. While I am extremely saddened by Thomson Reuters' decision to kill StockVal later this month, I know that as I transition to Baseline I will encounter some improved data and functionality. For a decade, I have been unable to screen on short-interest, but that is no longer the case.

As I was running through my watchlist, where I knew that there were some good companies with very high short-interest, it dawned on me that the broader market might be seeing some of the same thing that I have enjoyed in some of the stocks in the Top 20 Model Portfolio like Allegiant (NASDAQ:ALGT), Buckle (NYSE:BKE) or Family Dollar (NYSE:FDO). Massive moves in heavily shorted names has been one of the factors that accounts for the strong double-digit return year-to-date.

Anyone that follows my views knows that I am not surprised by the move to new highs this past week. I detailed my outlook in January that the bear market rally should continue into late March or early April. This weekend, I updated my views to subscribers to Invest By Model that I am beginning to become a bit more vigilant for a near-term peak.

Back to the task at hand, I screened the S&P 500 for stocks with more than 10% of the float short - not an easy task for these large companies. In fact, though, 46 companies met the criterion. In the table below, sorted in descending order by sector, you can see that the shorted companies come from all over the place:

SHORTS SP5 032010
The S&P 500 price return is about 4% year-to-date. While short-covering surely isn't the primary reason, the heavy concentration of names in the Consumer Discretionary and Financial sectors highlights the potential relevance of this factor. While the Industrials sector leads the way for the market so far in 2010, these two other strong-performing sectors which comprise 25% of the index are chock full of exploding over-shorted names. The Consumer Discretionary names are up 14.1%, while the Financial names are up 13.5%. The sectors were the worst in 2008 and middle-of-the-pack in 2009. In every sector, the average return of the shorted names exceeds the sector average, except for Industrials (thanks to First Solar (NASDAQ:FSLR)).

While this is interesting to me, I don't know that it gives us too much insight into what the future holds. It just tells us that one of the reasons the market is doing better is that there has most likely been some short-covering. If you are skeptical, consider the S&P 400 Mid-Cap index, which is up 8%, or double the S&P 500. As I explained (or didn't explain!) at the end of February when I reviewed returns, there isn't a structural or compositional difference that would explain the radically superior performance. I suggested that it could be the improved M&A environment, but might it be that 25% of the Mid-Cap index is shorted in excess of 10%? The S&P 600 Small-Cap index, which is also up about 8%, has 27% of its constituents shorted in excess of 10%. Now I know!

Disclosure: Long ALGT and BKE in a portfolio I manage and long ALGT, BKE and FDO in one or more model portfolios.