Before the bankers, short sellers were the pantomime villains of the credit crunch…
And whether or not they deserve such notoriety, short sellers are an important force that affects us all. Their buys and sells dictate where the market goes next. However, by understanding what they do and how they work, you could time your stock buys perfectly and make money.
Put simply, short sellers sell high and buy back low. They spot an overvalued stock that could fall in price, so they borrow some shares from a brokerage firm or pension fund and sell them. If the price drops, they buy back the shares, return them to the lender and pocket the difference as profit. If the price rises, the seller still buys them back and ends up taking a loss. It’s like old fashioned trading but back-to-front.
Because short sellers profit when the price falls, they are often blamed when shares fall. However, we don’t see the point in moaning about them. And in fact, if you know how they play the game and can spot when they’re at work in the market you can make money from the next stock to get short sold. Let me explain…
It’s Groundhog Day on the stock market… Stocks fall then rise and then hit resistance and fall back down again. For all the gains they’ve seen, none of the major indices have broken the downtrends they are locked into. The FTSE 100 may currently be 14% up from the lows on 3 March, but it’ll be for nothing if the market cannot break the downtrend.
And it doesn’t look too promising. You see, no one is actually buying.
The reason the indices are going up is not because pension funds or foreign sovereign wealth funds are throwing billions into the beleaguered UK stock market. Far from it. In fact we are seeing little data supporting any new major investors entering the market.
The market rallies are caused by something known as “short covering” and it goes like this…
Three steps to a bear market rally
How to manufacture a rally even in a bear market:
- Short sellers borrow stock to “go short” in companies expected to underperform
- The short sellers profit from the falls in the stock over the next 30 days
- With the position in profit, they choose to bank the gains and buy the stock back (“cover their short”) to level out their position. The net result being that, with one short sell and a correcting buy, the short seller’s position is neutral and they leave the position with their winnings.
This is evidenced by the movements of the much maligned banking sector. You may have noticed that during bear market rallies, the banks tend to shoot up faster than the rest of the market. To a casual observer it seems bizarre that investors would be punting on such a volatile sector. Indeed, the major research houses continue to rate the sector as a Sell with a capital S.
The real reason these shares are rallying is because they previously had significant “short interest”. In other words, more people were short selling them. When the bank shares stop falling, short sellers cover their position which artificially causes a rise in the share prices. Meanwhile, traditional investors are getting burnt mistaking these bear rallies for the real thing.
So with short covering (rather than fresh money being put to work) as a primary catalyst to bear rallies, it’s little wonder that the FTSE struggles to breach 4000 and get out of the downtrend.
However, there’s no point in letting this phenomenon chip away at your wealth. There’s a way to profit from this short covering rally, if you know where to look…
How to profit from a short covering rally
You see, a large number of short sellers take profits by covering their positions. This then often leads to other investors buying on that new upward momentum and can see the particular stock outperform the market. It is the most beaten-down stocks that tend to benefit most from a short covering rally. The trouble is that it is tough to know which stocks have the most short interest.
However, that could all be about to change as short selling experts Data Explorers announce their new index (called the DESLI UK 30) which will track the short interest on the largest 30 stocks in the UK. You can access this index at http://www.dataexplorers.com/sli_uk30 to track the short interest of stocks like BP, AstraZeneca and Tesco.
Rising levels of the DESLI UK 30 shows short sellers are increasing their short positions in the stocks listed in the new index. It is when those levels are at their peaks that contrarian investors would be best served to buy. Indeed, most recently short interest peaked on 9 March, at the beginning of the most recent bear rally. The times when shares are beaten down is when the short sellers tend to take their profits and buying pushes shares back up.
When the cycle ends, the short sellers cover their positions and buy back the stock. This could spur price rallies and if you have bought in at the time when short interest was at its peak, your positions will rally too. For example, the Data Explorers research page currently shows that FTSE 100 firm Prudential is a growing short position, with over 1% of market cap on loan being short sold. Pru shares are falling, and if they continue to slide, expect a sharp reversal. This represents an opportunity for buyers to make some money.
Best wishes,
Theo Casey
For The Right Side
Editor’s recommendation: Theo Casey is Investment Director of The Fleet Street Letter, the team who predicted the Credit Crisis, the banking breakdown and the plunge in the pound. Click here to read their predictions of What Happens Next?
MARKET NOTES
The one indicator to watch for signs of Europe’s recovery
BY SHIVVY ARORA
To get a feel at how Europe’s doing, it’s worth looking at the Purchasing Managers Index (PMI) for the region’s manufacturing sector. This is the most crucial ‘turning point’ indicator for the economy, as manufacturing represents nearly a quarter of total Euro-zone GDP.
The PMI gauges orders, stock, employment and output levels in factories. In other words, it tells you how things are going in industry.
PMI values above 50 indicate an expected increase of business conditions. Anything below the 50 mark means a deterioration. So 50 is the “dividing line” between growth and contraction.
The chart below shows Eurozone PMI figures for March this year. Despite a recent upturn, you can see that the manufacturing PMI (black line) remains below 35, meaning manufacturing activity is still contracting sharply.
The “dividing line” that separates growth and contraction…
Now, if manufacturing PMI starts consistently climbing higher over the next couple of months, that’s clearly a bullish signal for the markets. But if it remains unchanged at a lower level, we can be sure the recession hasn’t released its hold.
But, don't wait for the PMI to reach the “dividing line”, because by that time, the stock markets will have already recovered! Remember, stock markets typically start to recover six to nine months before economies rebound. We’ll revisit this chart when we see some significant movement …
The Daily Reckoning – The dangers of infinite credibility
Buenos Aires, Argentina
Wednesday, 15 April 2009
The “End of the Rally is Nigh,” says Barrons.
Our old friend, Marc Faber, says he expects a 10% drop in the stock market before the rally resumes.
Maybe. This rally is going to end sometime. But it probably has a ways to go. There are still a lot of suckers who haven’t been drawn in.
Another old friend, Rick Ackerman, thinks the problem with this rally is capitulation... or rather, the lack of it. There’s been no capitulation, says he. And you can’t have a real bottom without it. No capitulation, no bottom.
The news from the economy is bad and getting worse.
Credit card debt has just taken its biggest plunge in 32 years... maybe ever. Credit card balances fell 9.7% in February. And the number of open credit card accounts is going down too.
What happens when people can’t pay down their loans?
“Mortgage delinquencies soar in the US,” says a Reuters article. Remember, delinquencies are the beginning of the process. Then come foreclosures and auctions – all eventually driving housing prices down further.
And when property prices fall, so does the collateral behind the banks’ and other financial institutions’ assets. So, their troubles aren’t over. The worst is still ahead of us, not behind us.
But despite the bad economic outlook, investors think the worst is past for the stock market. Markets look ahead, they say, beyond the immediate economic forecast. True, but they have an adorable habit of seeing only what they want to see.
“In January 2008, when the S&Ps were in the early stages of what was to become a devastating collapse,” explains Rick Ackerman, “domestic equity mutual funds were worth about $6.5 trillion. Lo, a little more than a year later, in February 2009, we see that the value of these funds had fallen by about 48%, to $3.4 trillion. But guess what: Over that time, net redemptions totaled only 2%, or about $100 billion! What that means, explicitly, is that mutual fund investors have stuck with this bear market throughout the decline.”
Investors didn’t give up on stocks – despite the huge decline in stock market prices. What that means is that there’s still a lot of selling to be done. “This bear market will end,” he continues, “like every other bear market in history, with a wholesale dumping of stocks at prices that will make current values seem exorbitant in comparison.”
That’s why you use trailing stops. You want to be sure that when the selling begins your stocks get sold first – long before most investors finally capitulate…
Read on…
To read the Daily Reckoning in full, click here.
P.S. If you enjoyed this article you can find out more about our free email, The Right Side by clicking here.
