Bets on a decline in stock prices are at an all-time high. This phenomenon, surprisingly, could cause the market to rise. Vincent Deluard, global equity...

Share story

Analysis |

Bets on a decline in stock prices are at an all-time high. This phenomenon, surprisingly, could cause the market to rise.

Vincent Deluard, global equity strategist with TrimTabs Investment Research, says the high amount of short interest — at a record 3.57 percent for the S&P 500 — is a bullish sign. About half the stocks have short interest of 5 to 10 percent, which refers to the percentage of bets on price declines, says JPMorgan Securities equity strategist Thomas J. Lee in a report.

An investor sells short using borrowed shares. If he bets wrong and the shares go up, he might be forced to buy shares at the higher price to cover the position.

“Imagine that when the market is heavily shorted that is like everyone on one ship tilted to one side — heavy shorting pushes the market to one side, and the more people shorting, the more it tilts,” Lee says.

Given the magnitude of short interest, even a little bounce in the market could cause a stock-buying stampede to cover short positions, Lee says. Catalysts could include even slightly better-than-expected earnings reports, lower oil prices or merger talk. Financial and consumer discretionary stocks have the most to gain from short covering since they have the highest short interest, he says.

Since the beginning of the decade, short interest has peaked six times, Lee says. On average, in such periods, short interest rises for 11 months and the market declines 6 percent. In the current rising short-interest cycle, which began eight months ago, the market has lost 19.8 percent. When such cycles end, the market usually gains an average of 8 percent over four months.

Since short selling is riskier than long bets on a stock, it isn’t a good option for everyone, notes Charles Schwab Investment Management portfolio manager Paul Alan Davis. Even if a stock falls to zero, downside risk is limited. But in a short sale, a stock on a tear could prove unstoppable, which could spell catastrophic losses for an unlucky short seller.