Signal Type	Trade Date	Return since issued
		World	U.S.
			Nasdaq 100 (QQQQ) Russell 2000 (IWM) S&P 500 (SPY)

Market Update

After five consecutive weeks of gains, stocks retreated over the five-day span. After an uneventful session Monday that left the major indexes almost unchanged, a dollar rally caused stocks to lose ground the next day, with the S&P 500 shedding 0.8%. The weakness carried over early Wednesday, but the main averages proved their resilience by staging an afternoon rally that propelled them back into positive territory, the Nasdaq Composite finishing the session 0.6% higher. After the close, Cisco Systems reported disappointing quarterly results and issued a cautious outlook. The news caused stocks to gap lower at the open Thursday. Yet, the main indexes managed to recover a good chunk of their losses, as the Nasdaq Composite only trimmed 0.9% after having been down 2.1% early in the session. Selling pressure intensified Friday as investors decided to book profits on news that China might tighten credit by raising interest rates. After an initial tumble, stocks managed once more to move off their lows to leave the S&P 500 with a 1.2% daily loss.

The S&P 500 (SPY), Nasdaq 100 (QQQQ) and Russell 2000 (IWM) respectively lost 2.05%, 2.16% and 2.36% over the five-day span. All three ETFs remain located well above both their 50-day and 200-day exponential moving averages (EMAs).

For its part, our World portfolio posted a 3.23% loss this week. The portfolio consists of the 5 top-ranked world ETFs as of November 5, which marked the beginning of the current 4-week holding period.

Our current Buy signal remains in effect.

Trend Timing School

A review of short interest

This week's article focuses on a sentiment indicator many investors use to try to predict the direction of a specific stock or the entire market, namely the 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 theory goes that when short interest reaches extreme highs, it means that too many people are speculating that the market is due for a serious correction, which, in classic contrarian fashion, is an extremely bullish sign. Conversely, a low level of short interest means that the market is too complacent and is therefore due for a downturn.

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 Chart 1 below, is a contrary indicator used to determine the sentiment of the overall market.

Chart 1: New York Stock Exchange short interest (in million shares)


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 conversely 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.

The implication of an elevated short interest ratio is that all the 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.

Given all this information, let's return to Chart 1 above. We can notice that by early August 2008, the NYSE short interest reached an extreme high of 18 billion shares. The short interest ratio stood at 6 at the time. An investor checking the numbers back then could have therefore concluded that market participants were showing excessive bearishness and that the market was ready to take off. Well, as we all know by now, such an analysis would have proved completely wrong as markets, instead of rising, fell precipitously for the next three months on relentless selling by panicked investors. It is interesting to note that the level of short interest came down as the market dropped. This is because institutional investors who were holding profitable short positions started to cover them to bank profits. So far in 2010, short interest has remained fairly stable at around 14 billion shares and has not proved helpful in anticipating the wild market swings we experienced between early May and late August.

We can only conclude from all this that trying to interpret short interest levels to predict market direction is a dangerous game. 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. Investors should always treat short interest readings as secondary indicators and rely instead on price and volume action as the key ingredients of any successful timing system.

FAQ of the Week

Question: Do you factor in investor sentiment?

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 NYSE short interest discussed in today's Trend Timing School article which tracks the sentiment of short sellers, the Volatility Index 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 often as terrible at pinpointing the turning points as the average investor is.

Warm wishes and until next week.

The TimingCube Staff