Wednesday, October 8, 2014

Before you break out the bubbly...

If you believe the financial headlines, dovish commentary during the September Fed meeting, per this morning's release of the minutes, drove the Dow up 275 points today. While I concur that---given the timing of the initial bounce---the Fed likely lit the spark, I have a tough time with the notion that commentary confirming the dovishness of the doviest Fed board in history was by itself sufficient to move the market to such a great one-day extent. I'd say more than a small portion of today's advance had to do with short covering.

I've described short selling here before, but in case you missed it, it's the practice of selling securities not owned by the seller, who hopes to later buy them back at a lower price. More specifically: when one sells short a stock, one borrows it from one's broker. The shares will come from the brokerages own inventory, from one of its customers, or from another brokerage. The shares are sold and the proceeds are credited to the short seller's account. Ultimately the short seller must "close" by buying the same number of shares and returning them to the broker. If the shares are cheaper upon closing the position than what they were originally sold for, the short seller pockets the difference. If, however, the share price rises, the short seller can lose big time. As he'll be paying a higher price for the shorted shares.

I track the short interest ratio on the New York Stock Exchange Composite Index as well as on all of the major sectors. As of two weeks ago today short interest, virtually across the board, had been spiking higher. Meaning folks were betting big time that stocks were going to fall. And, for a few weeks anyway, the shorts---who've been on the losing end of a lot of bets these past few years---were making some serious headway. But then comes today. The market bounces on those Fed minutes and the shorts---I strongly suspect---panicked and rushed to cover their positions. Which means they were buyers today, in a big way. For---as I stated above---if stock prices spike above where they were originally shorted (sold), the shorts can get absolutely creamed. That rushing to cover (buying) pushes stock prices even higher.

Not that you shouldn't feel good about today's rally (unless, like me, you think a real correction [10+%] would be healthier), like I've been reporting; the fundamentals are okay and there's virtually no near-term U.S. recession in sight (not per the usual indicators that is). But 275 points on what served as simply confirmation that the Fed is in no hurry to raise interest rates? Nah... a bunch of today's move was due to short covering.

Speaking of today, the short interest ratios I track have come down a bit from two weeks ago---but they still denote fairly bearish sentiment overall. Which of course is a good thing if you're a contrarian bull, or if you're Warren Buffett. He says he gets greedy when others are fearful.

Stay tuned...


1 comment:

  1. […] action supported my hunch (as I reported to you Wednesday night) that Wednesday’s action was more about short covering than it was […]