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Rally or No, Short-Selling Hits a High

In spite of the incipient rally in stocks over the past few weeks, many investors don’t think it will last, judging by new data on short-selling.

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In a short sale, an investor borrows shares and sells them in hopes of repurchasing them later at a lower price and pocketing the difference.  Outstanding short interest, or the number of shares that have been sold short, is at its highest level since mid-2009, according to Data Explorers, which tracks securities lending.

The spike in bearish bets comes as stocks turned positive for the year this morning as the Dow rose more than 100 points, thanks to better-than-expected retail sales. So far this month, the Dow is up 3%. And while the Dow is still down more than 6% from July — before the recent market turbulence — it could finish in the black if it holds this morning’s gains.

For investors, interpreting the increase in short-selling is tricky.  Rising short interest often means sophisticated investors see trouble ahead and expect prices to fall.  But because short-sellers must eventually buy shares to close their positions, extremely high short interest can be a bullish sign. That’s because a rise in stock prices can produce paper losses for short-sellers, causing some to buy in order to close their positions and limit losses.  That buying can push prices even higher, scaring more short-sellers —  what’s known on Wall Street as “a short squeeze.”

Short-sellers could get squeezed soon if the market continues rallying, according to Ryan Detrick, a senior technical strategist with Schaeffer’s Investment Research. That would mirror a recent jump in the euro that, as the Wall Street Journal reported yesterday , analysts believe is largely due to short-sellers abandoning their bets.

Short interest is also a sentiment indicator, say market experts, and that sentiment can sometimes become so bearish that it becomes a good sign for bulls.  There are other signs of gloom now: The Investors Intelligence poll shows fewer investors are bullish than any time since March 2009, Detrick says. Hedge funds have just 45% exposure to stocks, after subtracting their short positions from shares they own.  That’s well below their typical stock exposure and approaching the 42.5% level they hit in March 2009, he says.

That month, the stock market hit its bottom of the financial crisis, so it would have been an excellent time for a contrarian investment.

One word of caution, says Detrick: “Just because there’s bearish sentiment doesn’t mean the market has to go up,” Detrick says. “There was a lot of bearish sentiment in October 2008, and the market kept going down.” But a lot of bearish sentiment can turn a small rally into a major one if plenty of investors change their minds and join the buying, he says.


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    • This extreme bearishness is actually quite bullish. Watch for more hedge funds going bust and closing over this next 6-12 months. There is going to be a lot of big money lost. If you think a hedge find mgr taking a fee plus 20% of the profits is sustainable just wait. Hedge funds will go the way of Madoff and other pied pipers. Just like Goldman Sachs Global Alpha Fund.

    • Unconventional Economics: Operation Twist 2 is QE3 – October 15, 2011
      by Slipposlappo

      In 1961, the Federal Reserve instituted a policy known as Operation Twist wherein short-term treasuries were sold and long-term treasuries were purchased; the intent was to encourage the strength of the dollar with increased yields on short-term treasuries and to encourage investment with decreased yields on long-term treasuries. What would a modern version of Operation Twist achieve assuming it was the only policy in action? Short-term treasuries would have increased yields (above the .25% currently), long term treasuries would have a decreased yield (below the 3.30% on 30Y treasuries on September 21, 2011; this date will be addressed later in the article), the dollar would strengthen as higher yields on short-term treasuries would attract buyers, the lower yields on long-term treasuries would encourage investment into stocks as lower yields on long-term treasuries provide negative real returns when inflation is factored in, and commodities would see their values go down as it takes fewer stronger dollars to buy the same product that once required a larger quantity of weaker dollars. Take note, these would be the modern outcomes if Operation Twist were the only policy in action.

      Capitalism has many mistresses, so it is no surprise that: “Honey, there are others.” As we recall, the Federal Reserve announced this summer that the Federal Funds rate will remain at 0 to .25% until mid-2013 in light of recent and persistent economic headwinds. Additionally, QE2 announced last year initiated a $600 billion bond buying spree that ended in June 2011, the result being extremely low short-term treasury yields (as the Federal Reserve is their dedicated buyer) and the lowest possible long-term treasury yields available without buying those long-term assets directly (low short-term treasury yields have a modest effect on long-term treasury yields as they only paint the picture of a small portion of the risk environment over a 30 Y treasury note’s existence). QE2 also weakened the dollar as billions were manifested from nothingness, and commodities went up in value as a larger quantity of weaker dollars were required to buy the same product that once required fewer stronger dollars. This September 21, 2011, Operation Twist 2 was announced, and unbeknownst to many, QE3 was initiated.

      Put very simply, starting October 3, 2011, Europe didn’t matter anymore for the United States. This was as a result of a massive government intervention NOT in Europe, but in the United States. Don’t believe this? To the charts we go!

      Operation Twist 2 should have made short-term treasury yields higher, but it did not. Examine the Federal Funds rate on the 1 Month US Treasury Yield and find that these rates are locked at nearly zero. These rates are locked in at 0 to .25% until mid-2013 as per another Federal Reserve policy. Consistently low short-term treasury yields are reminiscent of QE2.

      Operation Twist 2 should have reduced long-term treasury yields, but it did not. Examine the 30 Y US Treasury Yield and see that the yields did initially fall to about 2.8%, but once the bond buying by the Federal Reserve began on October 03, 2011, the yield actually increased to 3.22%, and continues its steady climb upwards. Higher long-term bond yields do not necessarily reflect QE2, but they do reflect a belief amongst investors that they should receive higher yields for inflationary pressures that they will inevitably encounter over a 30 year lifespan. In that case, this demonstrates a great deal with respect to what investors believe an inflation-appropriate return on a 30 Y treasury should look like. Think about that: Inflation! Just a few days ago everyone was worried about deflation and negative GDP. Inflation makes bond yields increase and the stock market rise exponentially. Any questions, just ask the 80’s. Once again, the prospect of inflation is reminiscent of QE2.

      Operation Twist 2 should have made the dollar stronger, it did not. While the dollar did strengthen between the announcement of the program on September 21, 2011, and before the long-term treasury purchases were initiated on October 03, 2011, the result since the purchases have been made is a falling dollar. Examining the USD Index, the dollar has fallen off of a cliff since Operation Twist 2 was initiated. Operation Twist 2 has made the dollar weaker as did QE2.

      Finally, commodities should have decreased in value as stronger dollars are required in a smaller quantity to purchase the same dollar valued commodities. Following the Federal Reserve’s announcement of Operation Twist 2 on September 21, 2011, commodities did fall as evidenced by the Dow Jones-UBS Commodity Index. This, however, was reversed starting on October 03, 2011, when the commodity index skyrocketed following the actual initiation of the Operation Twist 2.

      Receiving massive amounts of cash as bond outflows are invested into stocks; the stock market has rocketed above the once insurmountable 50 day simple moving average and will continue upwards at least to grab a hold of the 200 day simple moving average. It is likely that the SP500 will cross the 200 day simple moving average as it begins a new bull market.

      Why is Operation Twist 2 not occurring as intended? There are three schools of thought:

      1) The Federal Reserve decided to buy the long-term treasuries but delayed the sale of the short-term treasuries, resulting in an increased balance sheet and the creation of dollars.

      2) The Federal Reserve scared away actual real-life buyers of long-term treasuries as those buyers realized that the Federal Reserve wasn’t buying treasuries from actual real-life individuals, it was actually just buying long-term treasuries it manifested into existence, resulting in an increased balance sheet and the creation of dollars.

      3) The Federal Reserve decided to buy long-term treasuries and did not delay in the sale of short-term treasuries to fund the long-term treasury purchases. However, the Federal Reserve in a separate statement made it clear that short-term yields are to remain near zero, so the Federal Reserve creates money so as to remain the dedicated buyer of short-term treasuries and to keep true on its near-zero yield promise. As a result, the balance sheet is increased and dollars are created.

      Europe officially doesn’t matter anymore as the Federal Reserve is essentially executing QE3 and European leaders are saying, “Move along, nothing to see here.” Dollars are being created; trade against that notion at your own risk.

    • Thedow is up 3% this

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