This year’s drop-off in the number of short shares in the Spider S&P 500 ETF’s (SPY US) has been characterized as an inescapable capitulation by the market bears in the face of an 8+ year bull market and a canary call of a market correction. Analysts and traders are quick to point out that the last time this few SPY shares were shorted was May 2007, just prior to an almost two year market slump which saw the S&P decline by over 800 points, or 55%.
To paraphrase Mark Twain, there are “lies, damn lies, and shares shorted”. To infer that this drop-off in the amount of SPY shares shorted is a signal that the overall market is on a brink of a 55% downturn and that bears, as per ZeroHedge “have thrown in the towel” may be a bit overreaching. Short interest in the 3 ETF’s declined going into the end of 2016 and have grown almost 10% in aggregate in 2017 – the bear is still out and prowling around in the woods.
Using “shares shorted” as a metric for short interest or “bearish sentiment” is a misapplication of statistical reasoning. Investors are interested in currency based returns not increases in the number of shares of stock they hold. They prefer a takeover announcement that raises the value of their holding rather than a stock split that increases the number of shares they hold, but not the value of their holding.
To equate the value of one short share of SPY ETF from 2007 to one short share in 2017 is also misleading. One ounce of gold was worth $650 in 2007 but is now worth $1,260; a 2007 Koenigsegg CCX had an MSRP of $695k but is now worth over $1.5 million; and one share of SPY was worth $148 in 2007 but is now worth $234. Investors do not trade, measure risk or their P/L based solely on number of shares they are holding. VAR models do not measure outstanding risk by shares in a position but rather notional dollars at risk, and a trader’s profitability is not measured by the amount of shares he/she is holding but rather the net worth in dollars of securities and cash he/she has in his/her account. Otherwise, everyone would be selling their Amazon.com (AMZN US) at $912 and buying Dryships Inc. (DRYS US) at $1.26.
The last time the amount of SPY shares shorted was this low was in May of 2007, but in actuality the notional amount of SPY short interest is actually up in 2017. Today’s SPY short interest is $42.6 billion, up $1.8 billion, or 5%, for the year. To look at the SPY ETF as a standalone proxy for investor sentiment is akin to standing in Times Square and trying to extrapolate New York City’s population. The two other most shorted ETF’s are the iShares Russell 200 ETF (IWM US) and the PowerShares Nasdaq 100 ETF (QQQ US) whose notional short interest are also up for the year. IWM’s short interest is $15.4 billion, up $1.3 billion, or 9% in 2017 and QQQ’s short interest is $7.5 billion, up $2.6 billion, or 54% in 2017. In aggregate, short interest in the three most shorted U.S. major market index ETFs is $65.5 billion, up $5.7 billion or 9.6% for the year.
You can partially blame the VIX for the decline in major index ETF short interest over the last two years. With most of today’s ETF short activity associated with hedging activities, the decline in the VIX index has significantly reduced the amount of ETF’s that need to be shorted in order to hedge a portfolio. With the VIX averaging 12.09 in 2017, the delta, vega and gamma components in hedging algorithms are much lower than when the VIX averaged 15.84 in 2016 and 16.68 in 2015.
The increase in major index ETF short interest from 2007 to 2017 can be partially attributed to the fact that the hedge fund industry in general has grown by almost a third over the last ten years. A $1 trillion growth in hedge fund AUM from $2.2 trillion to $3.2 trillion would necessitate a significant increase in the size of major index ETF hedges.
While notional short interest in all three major index ETFs increased in 2017, the total short interest has declined compared to the average short interest in 2015 and 2016. This decline, which began in 2016, occurred two thirds into this 8+ year rally, a lagging indicator to say the least. While SPY short interest declined versus 2015-16 averages, short interest in the IWM and SPY ETF’s actually increased, sending mixed signals as to whether the investors are still bearish or not.
The number of shares shorted in a security is important when comparing to daily average trading volume to see how long it will take to get in and out of a position, but when looking for comparative short activity or investor short conviction, dollar notional short balances paint a much clearer picture.
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Head of Research, S3 Partners
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