Trader’s Narrative

A bull market climbs a wall of worry. Or so goes the Wall Street maxim. The market has a love/hate relationship with bears (and they with the market) but it needs bears fervently. A bull market feeds on bears and their panic, fear, caution and disbelief.

A great way to quantify the bears and their activity (as opposed to just their sentiment) is to track short interest positions. This data is released by the NYSE and Nasdaq exchanges on regular intervals. And although like the commitment of traders, it is somewhat dated data, it is still very useful.

But it can get tricky because we can’t really start comparing today’s data to say 5 years ago. If you look at a chart of short interest you notice that it just keeps going up and up (the opposite of cumulative breadth). That’s because the market, trading volumes, number of listed securities, etc. have all increased. So somehow we have to convert a series into an oscillator to extract meaningful data. There are a few methods but the most simplest is to track the data series relative to a moving average of itself. Another is to compare it to the daily average volume in the market. This is called short interest ratio.

Right now both Nasdaq and NYSE short interest ratios are at levels which show a remarkable disbelief in the bull market. Last month saw a 9% increase in Nasdaq short interest and the last 5 months a 33% rise. The NYSE short interest ratio is a bit more extreme than Nasdaq’s in fact. So as the market has continued to rise, more and more people are betting that it will fall.

All these short positions puts a floor beneath the market. If the market begins to fall, shorts will cover to profit (buy). A large short position can also be the fuel for momentum. If the market continues to rise, shorts will cover (buy) as their stop losses are hit.

Another measure is to look at odd lot purchases and odd lot short sales. These are transactions made with less than 100 shares, therefore they must have been made by small traders or investor. NYSE odd lot purchases and NYSE odd lot short sales are both in neutral territory relative to their historical extremes. The public doesn’t have very much conviction one way or the other right now.

As long as these two measures do not reach their extremes (for short sales, low levels and for odd lot purchases, high levels) we’re in the clear and the market can continue to climb. But sustained readings at those extreme levels would be bearish because the public would then have come to fully believe in the rally and throw caution to the wind.

But picture isn’t quite so uniform in its bullishness. NYSE public short ratio which measures only public traders/investors as opposed to specialists and member firms activities is a tad high. This is confusing because it doesn’t confirm the odd lot shorts measure. Who said this was easy? Perhaps this is because while the short interest data moves slower in an easily definable trend, the public short ratio and the odd lot measures are much more erratic and volatile. So we may very well see them quickly come into alignment with the short interest data.

On April 25th 2007, I wrote that gold bulls would be disappointed (again). Lets take a look to see what happened since then and what we can tell for the sector going forward.

I pointed to the Commitment of Traders report, which showed the “smart money” commercials being markedly net short. Since then that lopsided situation worked itself out.

On April 17th 2007, the commercials position was: long 79,882 and short 254,480, which is a net short position of 174,598 contracts. From the previous week (April 10th 2007) the commercials had reduced their longs (-7,564) and added considerably to their shorts (+13,830). Meanwhile, the small speculators were long 54,973 and short 15,733, for a net long position of 39,240 (on April 17th 2007).

Now compare that to the COT on May 29th 2007. The commercials had a long position 125,989 of and a short position of 244,684 for a net short position of 118,695 contracts. And the small speculators were long 57,428, and short 33,630 for a net long position of 23,798 contracts.

An important metric to watch for the COT is the open interest. Currently it is at 425,688 contracts, a 12 month high. Usually important changes in trend develop when the market is positioned lopsided (commercials vs. speculators) and when the open interest reaches significant levels. We saw this happen in late February 2007 where the commercials had been increasing their net short position while the small and large speculators were going more more long. With the open interest at around 415,000 contracts, things hit their climax and it started to unwind.

As well, the Rydex sentiment measure was flashing a caution sign. Considering also that the gold index fell to an area of previosu support, it wasn’t surprising to see it rally last week. It started with hammer on Wednsday and then two back to back long range up days:

Last week may have gotten the gold bugs rejoicing. But when you step back and look at the larger picture you see a very lackluster performance. Relative to the general stock market, the gold sector has lagged significantly. It is stuck in a wide trading range and is no where near break out levels. If it does approach the 370 level without looking too overbought and if the k-ratio is low enough, then I might change my overall outlook on this sector.