Short-Selling Indicators
During the heyday of technical analysis from 1960 to 1985, some of the best indicators of market direction were the odd lot and public short selling ratios. High levels of short selling were positive for stocks while low levels were negative.
Unfortunately, with the emergence of index futures and arbitrage short selling in the mid-1980s, it became impossible to distinguish arbitrage short selling from short selling expecting lower prices, so short selling indicators waned.
This situation changed around 2007 with the creation of bearish ETFs. These funds made it possible to again measure investor "short selling." In this instance, however, investors weren't short selling directly but were buying ETFs that were.
As you’ll see, two indicators that measure buying of ProShares short funds point to continuing higher stock prices.
Investor Buying of SH
The first indicator measures how much investors are buying the ProShares S&P 500 short fund SH as a percent of assets. You can see from the chart that peaks in buying of SH occur at bear market lows, a fact we highlighted all last year.
You can also see that historically, major market tops don’t occur until short selling has first fallen to very low levels – down to at least 5% of assets. This fact is indicated by the arrowed lines.
To be clear, a low 5% reading doesn't necessarily forecast a market decline. It just means a major decline has never started until short selling has first fallen to 5% or less. It’s currently 12.7%.
If one believes in short selling indicators this implies we'll have higher stock prices before there is a significant risk of a lower market.
Confirming this is another short selling indicator made from all ProShares long and short funds. It divides the total amount of money going into all the ProShares short funds by all the money going into corresponding ProShares long funds. It's graphed below.
The green area is when more money is going into short funds than long funds, while the pink area is the reverse.
The chart shows that, over the long term, there's always more money going into the long side of the market then short side. In fact, it's very bullish anytime the ratio gets into the green area, something we pointed out all last year.
The conclusion from this chart is very similar to that of the previous chart. Historically, a major market decline has never begun until investors have been pouring at least 2 1/2 times more money into long funds than short funds. That's a ratio of .4. We've indicated past periods of low ratios with arrows.
To be clear, just like with the previous indicator, a ratio of .4 doesn't necessarily forecast a market decline. It just means a major decline won't start until the ratio has first dropped to .4. It’s currently .777.
A Wrong Forecast
Our market forecast over the last two months was wrong. For the previous nine months, we’d been forecasting a high of 4,800 on the S&P 500 before the market would turn lower, but accelerated the bearish forecast based on rising interest rates. We viewed the decline that started in July as the beginning of the second wave down of the bear market. The rationale for it was explained in this October 2nd article, The Warren Buffett Bear Market.
The strong rally over the past three weeks has proved this bearish view wrong. So now what?
Even though we were bearish, our recommended asset allocation (allocation article) of 50% stocks, 30% long term bonds and 10% gold performed well during the rally. This stock-bond-gold allocation was chosen since it would both protect against a major price decline, which we expected, but also do well if our forecast was wrong, which it did.
This three week rally hasn't changed our overall view of the market, however. We still believe a second declining wave of 20% or more is coming, just that July wasn't its beginning.
These two short selling indicators, as well as other similar metrics, suggest the current rally has farther to go before we have to worry about a second major decline. As we originally thought, we believe the S&P 500 will reach its all time high of 4,800 before that happens. So we're satisfied with maintaining our current stock-bond-gold allocation and let the market, investor activity and time clarify the situation.
This article was written by
Michael James McDonald
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Michael James McDonald is a stock market forecaster, author and former Senior Vice President of Investments at what is now Morgan Stanley. He is a long-term advocate of the theory of contrary opinion and the measurement of investor sentiment when forecasting price direction.His first book, " A Strategic Guide to the Coming Roller Coaster Market" was published in June of 2000, three months before the top of the dot comm market. On its cover was written, "How a new model of the stock market predicts the end of the 18-year bull market (1982-2000) and the beginning of a new era." The "new era" was to be a long-term (roller coaster) trading range market, which did materialize between 2000 and 2009.Then, on August 31st, 2010, in a SA article titled: "The 10 Year Trading Range Is Over - The 'Final Stampede' Has Begun", he called an end to this trading range market and the beginning of another long-term bull market, which also came about. Through his company the Sentiment King, he continues to study and do what he loves - research and attempt to successfully forecast major stock trends - and help others see them too.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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