Trading Volume vs. Short Interest

Barry Ritholtz in “Watching Trading Volume Fade Out” points out that the March stock market rally, while producing impressive gains, has done so on falling trading volumes. This is an important technical indicator. The run up to the 1987 crash featured record highs on decreasing volumes.

Mind you, we aren’t saying there will be a crash. However, volume is a technical indicator that makes intuitive sense. If buyers are sitting on the sidelines, it says that there is a good deal of skepticism about current market levels.

And that skepticims is confirmed by a Ritholtz post from the day before, again on Seeking Alpha, “NYSE Experiences Record Short Selling.” But in the weird way markets work, some see high short interest as a bullish sign (if stocks continue to rise, many shorts will purchase stocks to cover their position, giving any increase more impetus). Ritholtz highlights the other effect of shorts: they provide a support to the market, because when prices fall, the shorts close out their position, again by buying stocks.

From Ritholtz’s post on volume indicators:

A few weeks ago, someone responded to a discussion about economic slowing with the following comment: “Price and Volume tell all.”

Fair enough: “What has VOLUME been telling you over the past few weeks?” I asked. Given the run off of the March lows has come on decreasing volume, it’s an important question.

Barron’s resident technician, Michael Kahn, picked up on the same idea in a recent analysis:

The stock market has put on a nice show with the Dow Jones Industrial Average rising some 5.5% off its March 14 intraday low. Along the way, it has ignored several technical barriers and even saw one major index, the New York Stock Exchange composite, set a new closing high.

But from the start of the rally through this week’s action, trading volume has been conspicuous by its absence. Without volume, the market will soon run out of fuel, and under such conditions we cannot expect it to run much longer.

We have noted a similar issue with overall market volumes. Even worse than low volume is the increasing volume during selloffs, and decreasing volume during rallies. This suggests to me that we are now transitioning from a period of accumulation (institutional buying) to a period of distribution (broader selling).

It’s not limited to the NYSE or S&P. Trading on diminishing volume is seen on many popular ETFs, including Dow Industrials (DIA), Nasdaq 100 (QQQQ) and other commonly traded ETFs. Kahn notes that “exchange-traded funds such as those covering the Dow, S&P 500, Nasdaq-100 and Russell 2000 all show the same volume declines, and this confirms that this condition is truly marketwide.”

Of course, volume can pick up at anytime and that would change this analysis. However, we can only analyze what is actually on the charts now and draw our conclusions from the evidence presented.

With most major indexes well below their February peaks, which are respective resistance levels, and volume drying up at a steady pace, the conclusion has to be that the stock market is now running on empty.

That’s a fair warning. We will be watching volume activity closely over the next few days and weeks to see how this develops further . . .

And the post on short interest:

No wonder China’s 4.5% correction had so little impact here: There are a record number of bearish bets made on the NYSE.

We had mentioned back in October that the then record-setting short interest on the Nasdaq was precluding a major correction from occurring.

Today, we see a similar record setting short selling having the same impact — only this time, it is on the NYSE instead. From this morning’s WSJ:

“Short-selling activity jumped to another record on the New York Stock Exchange despite the tepid returns that such bearish bets have garnered so far this year.

For the monthly period ended April 13, the number of short-selling positions not yet closed out at the New York Stock Exchange — so-called short interest — leapt 4.6% to 10,989,496,813 shares from 10,510,404,017 shares in mid-March.

Market-wide, the short ratio, or number of days’ average volume represented by the outstanding short positions at the exchange, fell to 6.1 from 6.2.”

Despite a myriad of potential pitfalls facing the market, that we have noted in the past, overly large short selling creates a bid beneath the market. When grateful shorts cover, they prevent any downside momentum from developing.

If part of your thesis is investing due to “variant perception”- the belief that you have figured out something the rest of the investment community hasn’t – then statistically speaking, the short side isn’t really the ideal place to be when short interest is at record highs.

At that point, shorting is more akin to consensus investing, going along with crowd. Even if you do so independently . . .

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