Short-Interest: Being Bear Is Back In Vogue

| About: SPDR S&P (SPY)

Summary

The Down-Side Speculators Are Drawing In New Recruits.

Defensive Sector Leadership Betrays a Sustainable Market Rally.

S&P 500 Upside...? Only for the Courageous.

The intraday reversal seen on Wednesday January 20th was confirmed last Friday following a break-out to the upside by the key U.S. indexes, after five sessions of tense stagnation.

In a recent weekly commentary (fortuitously written on January 19th), we recommended to our clients not to give in to the panic selling (Too Late To Panic...For The Moment), and subsequently made a client call to open tactical longs on the Jan. 20 close.

While Friday's strong move to the upside could see follow-though this week, we remind investors not to be seduced by the sirens of Wall Street with their ubiquitous soothing messages. No, the January sell-off did not correct 7-years of market disequilibrium. No, valuations still matter. No, we are not still in a bull market. No, the 2016 year-end consensus target of 2,200 on the S&P 500 is still a sell-side ploy to enhance bank business. Why are we so resolute in our analysis? We espoused our reasoning last week in our weekly commentary, Selling Into This Rally - Our Top Ten.

Over the next couple weeks we have three items we'll be watching: (1.) the rising short interest in U.S. stocks, (2.) the leadership in the current rally, and (3.) a possible break-down of the correlation between crude oil and equity indexes.

Short-Interest: Being Bear Is Back In Vogue

This past week we looked at short-interest in the S&P 1500, which accounts for over 85% of U.S.-listed stocks. We first consider here the short interest data (which is released bi-monthly) expressed as a percent of float. To recall, the "float" is the total number of shares outstanding and traded by the public (or similarly, total shares issued by all companies less shares held by the firms' treasuries). The chart below shows the long, steady decline in short interest during the bull market (black oval). Looking back, short interest hit a minimum back at the very beginning of January 2014. Recall also that the U.S. bull market peak occurred in May of 2015, so short speculators began visibly nibbling at this market well over a year before the top. The chart also shows that since the trough, short interest as a percent of float has clearly broken the down-trend. The red oval highs the new uptrend in short interest. It is our belief that this uptrend will persist through much of 2016.

Click to enlarge

Given the long, grinding bull market of the past years, almost all bears were broken, battered, and expelled from the markets. This is seen in the short interest ratio, which aggregates short interest from the NYSE, Nasdaq, and AMEX relative to total volume on the exchanges. The short interest ratio measures how many days it would take to cover the short positions if positive news began lifting the markets. The higher the ratio, the longer it would take to buy back the borrowed shares, and therefore the less attractive is short-selling.

We plot the short interest ratio (in olive green) along with a 24-week smoothing of the data (in blue). The chart below exemplifies the pain suffered by bears over the past seven years. The short interest ratio has climbed all the way back to the prior bull market peak. Perhaps a rallying point for the bears? Looking at our smoothing of the data in blue, it is clear that, for the first time since 2009, the curve has NOT made a higher cyclical high. Moreover, our trend support line is being violated. This merits watching. When shorts get confidence, money can be made in a hurry, and aggressive speculators pile in and accelerate downward momentum in the markets.

Click to enlarge

Defensive Leadership - A Characteristic of Bear Markets

It is instructive to look at which sectors have led the markets higher since the January 20 market low. The table below presents the GICS level 1 sector indexes along with some other important indexes.

Sector/Index

Performance Since Jan. 20, 2016

S&P Energy (NYSEARCA:XLE)

+11.86%

NYSE Arca Gold Miners (NYSEARCA:GDX)

+11.07%

S&P Telecom (NYSEARCA:IYZ)

+9.37%

S&P Utilities (NYSEARCA:XLU)

+5.47%

S&P Consumer Staples (NYSEARCA:XLP)

+5.30%

DJ US Select Dividend (NYSE:DVD)

+5.29%

S&P Info Tech (NYSEARCA:XLK)

+5.27%

S&P 500 (NYSEARCA:SPY)

+4.35%

S&P Consumer Discretionary (NYSEARCA:XLY)

+4.34%

S&P Industrials (NYSEARCA:XLI)

+4.17%

S&P Financials (NYSEARCA:XLF)

+3.98%

Russell 2000 (NYSEARCA:IWM)

+3.61%

S&P Materials (NYSEARCA:XLB)

+3.39%

S&P Healthcare (NYSEARCA:XLV)

-0.60%

Click to enlarge

The broad market S&P 500 is up +4.35% through the close on Friday Jan. 29. It should not be reassuring that the Telecoms, Utilities, Staples, Gold Miners, and Dividend stocks are the leaders. We went back and looked at the corrections starting in April 2010, July 2011, and August 2015. In each case, the cyclical indexes corrected more than the S&P 500, but also bounced back stronger than the broad market. If current defensive leadership continues this week, this will further confirm that this pull-back is different…and constitute yet another sign to sell the rally. Dip buyers beware.

Will Crude Oil and Equities Decouple?

Equities have fallen in sympathy with oil prices since December. And for the past week, equities have accompanied the rise in oil prices. Now, will the front month West Texas Crude contract tucked up just below the downward trend resistance, a hair under $35 (as of last Friday's close), we've arrived at a cross roads (see chart below). We'll see right away this week if equities can carry on higher, even if crude oil faces strong selling against this key level.

Click to enlarge

Conclusion

We are looking for overhead resistance on the U.S. indexes in the coming weeks to send the markets back down to new multi-year lows. On the S&P 500, the 50-day moving average is falling and currently at 2007.65, while a standard Fib 61.8% retracement from the November high is a 2000.28 (which is conveniently near the December swing low). Only the courageous will hold on until these levels to sell. Readers can follow regular updates in our Trade Log to get our latest market outlook.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.