Monday, June 4, 2007

An Interesting Technical Development

This is from the daily newsletter from Schaeffer's Research:

Caution and skepticism prevail across Wall Street and Main Street, as investors have yet to fully buy into the market's upward momentum. Institutions and hedge funds, which dominate trading in the U.S. market, continue to hedge their long positions by shorting other stocks, shorting index futures, and purchasing index put options, which are among the most-active options on a daily basis.

Mutual-fund players aren't terribly sanguine either, preferring to avoid the playing field. In 2000, when the SPX was last in the 1,550 area, domestic stock funds enjoyed $259 billion in inflows. As of the end of April, domestic stock funds are on pace for only $63 billion in inflows this calendar year, as investment dollars continue to chase overseas markets. All of the broad indices are hitting new highs, yet the public is still not engaged. As contrarians, this is a welcome indication that plenty of money still lingers on the sidelines.

As an example of the pervasive shorting activity that continues as the market achieves new all-time highs, odd-lot short selling continues to build momentum. The smoothed 20-day moving average of odd-lot short positions has been slowly building up speed for the past 2 years and is now near a 7-year peak. Some are viewing the increased shorting activity as the work of hedge funds and thus not an indicator of pessimism surrounding stocks, with the implications being that short interest can no longer be used as a contrarian bull signal. My view is that regardless of the motivation for the huge short positions, they have to be unwound at some point in the future and thus represent future buying power.

Let's look at these developments in a bit more detail.

The lack of participation in the US market by the "little guy" is interesting. My guess is there is a combination of factors at work.

1.) A long hangover from the 2000-2001 sell-off.

2.) The number of people who respond the country is on the "wrong track" in political opinion polls has been very high for about two years. I am wondering if people's perception of the economy is negative as well.

3.) There is a large amount of skepticism about the market's advance.

In addition, the large short position in the market provides tremendous upward pressure. As the market rises, shorts have to cover their positions.