Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500

Market Update

Markets resumed their march forward this holiday-shortened week, as most major indexes posted gains for four days in a row. The Dow Jones Industrial Average, the S&P 500 and the Russell 2000 all closed the week at new record highs while the Nasdaq 100 finished at its highest level since mid-2001. It is interesting to note that small-cap stocks have regained their form, after trailing their large-cap counterparts for most of the rally that started mid-March. Stocks were helped this week by more takeover deals and positive news about the economy. Worries about the chinese market resurfaced Wednesday but were not enough to derail the market this time around as stocks managed to close higher on the day despite broad weakness at the open. The minutes of the Federal Reserve's last meeting were also released Wednesday. While it is still concerned about the level of inflation, the Fed noted that risks to the economy have diminished. Investors apparently liked what they read as they pushed the market higher after the minutes were disclosed. The May employment report was released by the Commerce Department on Friday. Nonfarm payrolls rose by 157,000 last month, more than had been anticipated by analysts, while the unemployment rate remained at 4.5%. These figures imply that the economy is basically sound. This was also confirmed by the latest ISM manufacturing index, which came in at 55. A level above 50 indicates that the manufacturing sector is expanding. Finally, we also had good news on the inflation front, as the core PCE, which is the Fed's favorite inflation gauge, only increased by 0.1% in May.

The Russell 2000, Nasdaq 100, and S&P 500 respectively gained 2.83%, 2.06% and 1.36% on the week. All 3 indexes rest above both their 50-day exponential moving average (EMA) and 200-day EMA.

For its part, our World Index Ranking portfolio matched the Russell 2000 performance by posting a 2.82% gain this week. The portfolio consists of the 5 top-ranked world indexes as of May 25, which marked the beginning of the current 4-week holding period. Our current Buy signal remains in effect.

Trend Timing School

Short interest

Much of the focus of financial analysts these days seems to be about all the reasons the economy and the stock market are in clear and present danger of collapsing, thanks to the now familiar and predictable culprits: the worsening housing and automotive sectors, the sub-prime loan industry's woes, record deficits and exploding national debt, two lingering and draining wars, spiraling energy costs, and now the slowest economic growth since 2002. In the meantime, the big news of the week are the new highs posted by various stock market indexes, with a special mention for the S&P 500's new all-time high which has the merit of being over seven years in the making (the previous high was set on March 24, 2000 at 1,527.46).

But instead of all this, our weekly article has to do with a much less conspicuous and glamorous record also established this week: a new high in short interest. And we are not talking about Attention Deficit Disorder. Short interest is the total number of shares of a stock or index which have been sold short and not yet repurchased. The reason we take notice is that while it means that a record number of people are speculating that the market is due for a serious correction, in classic contrarian fashion, this is extremely bullish.

As a brief recap, short sales are when a trader sells borrowed stock with the expectation to be able to buy it back later at a lower price, at a profit. It is a bet on the price of a stock going lower in the future. Short interest is the total shares in short position. This is fundamentally an investor sentiment indicator. Closely related is the short interest ratio (the short interest divided by the average daily trading volume of the stock) which represents how many days of average volume it would take for all short positions to be repurchased.

While the short interest in a particular stock can be useful to traders, the New York Stock Exchange (NYSE) Short Interest, as depicted in the chart below, is a contrary indicator used to determine the sentiment of the overall market.

New York Stock Exchange short interest history, 1991-2007



As the chart shows, short interest on the NYSE rose to a record 11.76 billion shares in May, or 3.1% of the total shares traded on the exchange, and the highest since the early nineteen thirties. It is a 7% increase over the previous month, and the third record monthly reading in a row. Likewise, the short interest ratio of 7.4 for May is the highest since 1998.

It is quite unusual for such bearishness to occur concurrent with the multi-year highs we have been seeing in the broad averages and many wonder how to read this.

Surprisingly, there are two diametrically opposed views of why short interest matters and how to interpret it.

In the first analysis, looking primarily at individual stocks, a high or rising short interest ratio level indicates that there are a large or growing number of investors who believe the stock will go down, and for an individual stock this should always raise a red flag. Some traders endeavor to find profitable shorting candidates by the level of negative sentiment.

Instead of gambling on or against individual stocks on the basis of their short interest we much prefer to look at broad market measures such as the short interest of the entire NYSE as a market sentiment indicator. A high short interest ratio is an indication of the existence of a potential market driving force - short covering, and a low relative short interest ratio indicates a lack of such potential. Therefore, in a flat or rising market, a high short interest level suggests that the wall of worry is firmly in place and that there will be a large demand for stocks in the future by short sellers. Historically, this has supported higher prices. During market declines, high short interest levels have indicated the extreme pessimism that often occurs at market lows.

Contrary to intuition and logic, market technicians generally interpret high readings of the ratio, say 5.0 or more, as bullish and anything below 3.0 as bearish. If this is so, the 7.4 ratio for May 2007 must be bliss.

The implication is that all these shorted shares will have to be bought back sooner or later and when that happens, the new cash injection will spur the market forward. This is the short squeeze scenario the bulls are hoping for. If the shorts can be sufficiently rattled into believing that the market is headed higher, there could be a precipitated and unorderly covering of short positions.

The bullish scenario gets reinforced by other factors that traders betting against the market should take a closer look at. By historical measures, such as the Price/Earnings ratio, stocks are inexpensive compared to what they were at the height of the last bull market in 2000. Another discrepancy is the absence of wild and generalized enthusiasm (Greenspan's irrational exuberance) for the future of the stock market which invariably coincides with major tops.

Of course, short interest numbers should be taken with a healthy measure of skepticism for several reasons. As the data shows, short interest statistics can at best convey a general sense of how much betting against the market is taking place, but it certainly does not seem to provide any valuable timing data.

With the proliferation of hedged trading strategies, the short interest ratio has developed an upward bias. Assets in hedge funds (which are notorious users/abusers of shorting) has more than doubled over the last five years, and in general more participants are shorting than in the past, thanks in part to new consumer oriented products such as short mutual funds and ETFs.

Because of all the reasons cited above, neither the short interest nor the short interest ratio factor into our signals, but the way we see it, any indicator that lends strength to the currently prevailing trend helps our cause, even if only by providing some welcome reassurance and peace of mind.

FAQ of the Week

Question: Do sentiment indicators figure in the Model?

No. Investor opinion or sentiment indicators play no part in our Model.

There are numerous such indicators tracked by market technicians ranging from the very broad like the New York Stock Exchange Short Interest discussed in today's Trend Timing School article which tracks the sentiment of short sellers, the Volatility Index (^VIX) and the put/call ratio which focus on the attitude of option traders, to the very narrow such as those measuring the ratio of bullish and bearish investment newsletter writers. Don't think for a minute that narrowing to smaller and more specialized demographics enhances the indicator accuracy. The bottom line is that most sentiment indicators are good at measuring sentiment levels, but sentiment levels are bad at predicting market tops or bottoms.

The old Wall Street truism "The crowd is right in the trends and wrong at the ends" applies directly to this topic. An investor sentiment indicator may be good at telling you the general market trend but is as terrible at pinpointing the turning points as the average investor is.

Warm wishes and until next week.

The TimingCube Staff