April 7, 2010 / 7:21 PM / 7 years ago

Shorts fear bear trap as U.S. stocks rally

By Leah Schnurr - Analysis

NEW YORK (Reuters) - A near-vertical 70 percent rally in U.S. stocks should be the perfect moment for the bears to pounce. Instead, they are resisting the urge to bet against a rally many see as over extended, having been caught in too many traps this last year.

After being on the wrong end of the massive 2009 rally, so-called bears or short investors who seek to profit from falling stocks have retreated to the sidelines or pared positions.

Those who have tried to bet against stocks have seen their attempts run over by the market’s unimpeded advance.

In a missive written at the end of last month, well-known investment manager Doug Kass acknowledged that his September prediction for a double-digit decline in the S&P has been proven wrong.

Despite his belief stocks face headwinds that could ultimately stymie the rally, Kass, the president of Seabreeze Partners Management in Palm Beach, Florida, said he has pared back his short positions in the past month.

“There are times in life, as in money management, where discipline trumps conviction,” said Kass. “The short world has been decimated in the last 12 months.”

SHORT ON IDEAS

Short investors borrow a stock, sell it and seek to buy it back at a lower price to pocket the difference. If the price rises, shorts can be squeezed out, making the potential risk infinite.

Kass is not alone among investors who have thrown in the towel on short bets. In 2009, many shorts were crushed as the S&P 500 .SPX mounted one of its fastest rallies in history. In 2009 the Strunk Short Index, an aggregate of short-only equity funds, fell 35.4 percent, its worst performance since it was created in 1985.

No other bull market dating to 1962 has fared as well as this one’s 68.6 percent rise in its first year, according to Birinyi Associates Inc in Stamford, Connecticut.

Attempts to time a downturn in 2010 have been frustrated. According to the Commodity Futures Trading Commission, speculators in S&P 500 futures had a net short position of 72,247 contracts for the March 16 week.

One week later, most of them had given up, with the net short position falling to 6,204 contracts. The run-up in short positions through February and March represented one of the most concerted efforts to get ahead of an expected market downturn, but it appears to have been thwarted again.

As the market continued to climb this year, investors went with the rising tide and put money to work in equities, biding their time until a pullback appears more likely.

“I‘m not short because for the most part I can’t find ideas that seem to be working and I think other people might be in the same camp,” said Bill Fleckenstein, president of Fleckenstein Capital Inc. in Seattle. After being short for 12 years, Fleckenstein closed out short positions last year when he decided the strategy wasn’t working.

“MUSICAL CHAIRS”

By all rights, this should be a time to short the market. It’s been 42 days since the market has lost 1 percent in a day, according to Bespoke Investment Group of Harrison, New York. In that time the S&P 500 is up 8.75 percent - at the top of the range before a decline usually occurs.

Furthermore, as of Tuesday’s close, 93 percent of the S&P 500’s components were trading above their 50-day moving average, Bespoke said. Momentum indicators also suggest the S&P is overbought and has been for a couple of weeks now.

However, there are reasons the market has resisted the desires of the shorts. The CBOE Volatility Index .VIX, Wall Street’s so-called “fear gauge”, closed at its lowest level in two-and-a-half years on Tuesday, back to the range seen when the S&P 500 hit a closing high in October 2007. Low levels on the VIX suggests investors are more likely to be complacent.

As well, optimism over the economic recovery has taken a stronger hold. Data has pointed to a steadily improving economy, exceeding expectations of economists.

It’s these beliefs that have played a part in tempering the bearish bets. Short interest on the NYSE has been ticking up since the end of last year, sitting at 14.1 billion shares in mid-March compared to 13 billion at the end of December.

But bearish bets are still short of July 2009 levels, when more investors were convinced the rally wouldn’t have legs.

Rather than a sign of increased bearish sentiment, analysts say the gains suggest investors are using short positions as part of other strategies such as hedging and arbitrage. A true negative turn would generate a larger spike among the shorts.

Paul Mendelsohn, chief investment strategist at Windham Financial Services in Charlotte, Vermont, was using short positions as a hedge against a potential fall at the beginning of the year but decided to go fully long at the beginning of March as the risk of a pullback diminished.

He hopes not to be among investors who get caught long when the rally stops.

“I don’t think things are going to end up as great as everybody thinks they are, but for the time being that’s not what the stocks are telling us,” said Mendelsohn. “My view is it’s a game of musical chairs.”

Editing by Andrew Hay

Our Standards:The Thomson Reuters Trust Principles.
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