Did short covering drive last week’s rally?

The strategy to “sell in May and go away” was working as well as it normally does - until last week! The US markets were up four days in a row for the first time since 2009, and the FTSE 100 is back above 6,000. The question to answer now becomes: was this genuine optimism that equity markets are the place to invest or was it less about real money flow and more to do with more short term factors? I refer to the fact that last week was both the quarter and month end. It is normal for fund managers to close certain profitable trades at these moments given the prevailing tendency to watch short term investment performance. This has led us to do some back of the envelope calculations to try and determine if short covering was a partial driver of last week’s rally.

The genesis for this piece came from my appearance on CNBC in the U.S. last week. It was not ideal to be scheduled to talk about the emergence of significant short positions in Specialty Retail and Food & Staples Retailing while all the chatter was about the biggest rally in years! So, when I got back we kicked off this rough set of calculations on US names to see if short covering was the driver of this rally, given that there has been a resurgence of short selling in recent months, and that much of it has been profitable given the shaky market conditions.

I will let the below table do the talking and suggest you draw your own conclusions, but here are some observations: Of the 67 GICS Sub Industry Groups (a type of quite detailed sector breakdown), 40 of them (or 60%) saw an overall decrease in settled short selling from Monday to Friday of last week. So we can at least say that during this period when the markets rose, those sectors which saw an aggregate of short covering comfortably outnumbered those with an increase. Further, the weighted overall price rise from those sectors that saw the aggregate closing out of short positions was higher than the aggregate price rise from those sectors that saw a net increase in short selling. To put it another way, sectors with the most short covering rose an average of 4.64% from Monday to Friday. Sectors with an increase in shares on loan rose by only 4.17%.

We have not adjusted this analysis to reflect specific movements in demand to borrow in big companies (because the study is weighted) that can skew the results. Yet, this rather crude view appears to show that there is some evidence that short covering contributed to last week’s rally.