March 12, 2008 / 9:40 PM / in 10 years

Short-covering behind US stock market recent gains

NEW YORK, March 12 (Reuters) - The dramatic rally on Wall Street this week was caused partly by traders who had been betting on declines moving to cover their short positions, another sign investors may see the credit market problems as far from over.

Financial shares led Tuesday’s rally, giving Wall Street its biggest gain in the Standard & Poor’s 500 index since October 2002, on hopes that credit strains may ease after the Federal Reserve pumped $200 billion into the financial system.

But Wednesday’s lack of follow-through was a signal investors were not quite convinced the worst was over for the market as financial company shares resumed their downward trend. The S&P financial index .GSPF fell 2.1 percent on Wednesday after gaining 7.4 percent on Tuesday.

“I think in the financials that was mostly short-covering than it was straight buying,” said Georges Yared, founder and chief investment officer, Yared Investment Research in Wayzata, Minnesota.

“I don’t think we’ve seen some strong buying yet on the financials,” he said.

Short-covering is when investors scramble to buy stocks that they had bet would decline in light of a turn to positive developments. Short-sellers seek to make money off of declines by selling borrowed stock in the hope of buying the stock back at a lower price to cover the loan, and pocketing the difference.

Short interest levels have been hitting record highs in recent months.

Last week, the New York Stock Exchange reported short interest jumped 4.2 percent in late February to an all-time high, surpassing a previous record from Feb. 15, suggesting an increase in bearish sentiment in the stock market.

And, at the close on Tuesday, short interest figures released by the Nasdaq exchange showed short interest on the Nasdaq also rose in late February.

Some analysts say there was very little new, or long-term money being thrown into the stock market.

“There are still underlying huge questions about the credit quality of the banking system,” said Fred Dickson, market strategist at D.A. Davidson & Co. Lake Oswego, Oregon.

“I think we’re in process of going through putting in kind of a prolonged trading range where we bounce up and down in short spurts.”

At the heart of the market’s unease is fallout from the housing market slump, which has rattled financial credits, causing credit tightening and fears of more loan losses for financial companies.

The credit turmoil also has raised worries about a U.S. recession, and the financial companies sector has been among the hardest hit in recent weeks as these concerns about credit markets and the economy have increased.

The recent figures also mean that there are “a lot of shorts to cover,” Harrison, New York-based Bespoke Investment Group founders Paul Hickey and Justin Walters wrote in a report Wednesday, noting it suggests the market has further to run in the short term.

Not all strategists saw Tuesday’s move as a short-covering rally.

“There was some short covering, but the dramatic sell-off in the 10-year Treasury market says to me money came out of Motherhood -- U.S. government bonds -- and some of it went back into the stock market,” said Al Goldman, chief market strategist at A.G. Edwards in St. Louis. “We’ve got high levels of cash on the sidelines, and some of it got spent.”

But some analysts noted that while volume on the New York Stock Exchange was heavier on Tuesday than it has been recently, it was not as strong as the market’s advance may have suggested.

“There’s still a tremendous amount of short covering out there, and we’re not seeing the volume that we should see associated with a (400) or 500 point move,” said Anthony Conroy, head trader at BNY Brokerage, a unit of Bank of New York.

The Dow rose 416 points on Wednesday, and saw its biggest one-day percentage gain since March 2003. (Additional reporting by Ellis Mnyandu and Justin Grant; editing by Leslie Adler)

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