Short squeeze not driving market rally

We recently highlighted that short interest in US large cap stocks had increased 22% over the summer to 3.13% of total outstanding shares. Today, we look at how short sellers have behaved following the recent upturn in the market, with the S&P 500 having posted strong returns of 6.1% since the start of October. Many market commentators have posited that the surge in the Index was due to short sellers being squeezed out of their short positions. In summary, we find that this is not the case. Short sellers have been covering their positions, yet this short covering has not necessarily driven share prices higher.

On the whole, short interest for the S&P 500 Index has fallen from 3.12% of shares outstanding at the end of September, to 3.02% on the 17th of October, a 3% decline. Looking at the changes in short interest, we find a roughly even split between shares which saw an increase and those that saw a decrease in short interest in the last 2 weeks.

It is worth noting that shares which saw a decline in short interest had an above average short interest of 3.7% coming into October, versus a below average short interest of 2.4% for shares which saw an increase in short interest.
 

Next, we tried to ascertain whether the short covering was in any way linked to the recent price increases. To identify this, we looked at the shares which saw the greatest changes in short interest and whether these shifts had were linked to the changes in price.

The 50 shares which saw the greatest amount of short covering since the start of October, posted a below market return of 5.8%, against an increase in the Index of 6.1%. On aggregate, short interest declined in this group by 21.5%.

Names that stand out from this list include perennial short First Solar (NASDAQ:FSLR) with short interest declining by 3.8% to 16.2% of total shares in the face of a 16% price decline and Netflix (NASDAQ:NFLX) which saw shorts cover by 2.7% to 6% of the total shares, while its share price rose by 4%.

The share which saw the best return in the face of heavy short covering was Sears Holdings (NASDAQ:SHLD) which saw short sellers pare back their bets by 1% of shares to 9.6% whilst the share price increased a staggering 26%.

To further establish whether short sellers were squeezed out by recent price movements, we analyzed the behavior of the 50 most shorted shares at the start of October and found that these shares performed worse than the 50 least shorted shares over the period. The heavily shorted shares saw a 6.4% average return compared to 8.2% average return for the lightly shorted shares. It is worth noting that only one share, Medtronic, Inc (NYSE:MDT), saw a decrease in price.

Finally, we looked at the behavior of short sellers in the shares which saw the largest price movements. In summary, there was little movement in short interest at both ends. We found that short sellers decreased their average bets by only 0.3% in the 50 shares which saw the greatest price decreases. They increased their positions by only 0.1% of total shares in the 50 shares with the greatest price increases. It is worth noting that shares which have performed well in the last couple of weeks had a below average short interest of 2.8% coming into October.

Bottom line

Short interest has retreated slightly in the last couple of weeks. However, this decline does not point to a short squeeze as the shares which have seen the greatest price increase actually had a below average short interest coming into the quarter and the shares which saw the greatest short covering underperformed the market.