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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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