Were short sellers behind the market crash or did they react to it?

Short sellers have come out of hibernation. But was this in anticipation or reaction to the August turmoil? Short interest in the S&P 500 is now higher than 3% of the total capitalization. With an average price earnings multiple of 21 across the index, we assess which sectors are attracting the most attention of hedge funds predicting further price falls – and of this short selling activity, how much is hedging?

Recent spike in short interest

The chart below shows that short interest in US large cap companies fell to its lowest level of 2.4% since 2008 at the end of July, before surging during August to peak at 3% - a level not seen since the end of November last year. But this should be viewed in context - demand to borrow and short sell has been subdued since the Lehman crash for a number of reasons: there are less hedge funds today and they are less leveraged, a prolonged bull market has meant it has been harder to pull off negative bets, regulatory uncertainty has sent many people to the sidelines, and short selling activity has tended to be confined to pockets of activity such as the Solar sector and some low-end retailers.

Pessimism expressed over Consumer Discretionary stocks

Amid reports of increased negative consumer sentiment, it won’t come as a surprise that the Consumer Discretionary sector is seeing the greatest amount of short interest, with an average of 4.3% of the total shares out on loan – up 14% over the last week alone. With the shares trading on an average multiple of 21 across the sector, institutional investors who lend their shares have maintained their holdings and still own 25% of the sector, which is broadly in line with the average across the S&P500.

GameStop Corp (GME) has appeared regularly in our screen of stocks seeing a fresh annual high in short interest. The company has struggled to adapt its business model to the impact of the Internet and has seen short interest surge to back to over 32%, making it by far the most shorted stock in the both the sector and S&P 500. Despite this, institutional investors who lend have kept faith and remain overweight the average for the sector, holding an impressive 44% of the company.

Pulte Group (NYSE:PHM), JC Penny (NYSE:JCP), Lennar Corp (NYSE:LEN) and DR Horton (NYSE: DHI) all see short interest fluctuate in between 15.5% and 11.8% respectively. They also have convertible bonds which can inflate demand to borrow the shares, but also see directional short selling activity.
 

Shorting ETFs as a hedge

We have discussed investor appetite to borrow ETFs to either hedge their long investments or express a directional view that a particular ETF following an Index or asset class is overvalued. The chart below shows the quantity on loan for all US denominated ETFs since 2008. Since the end of 2009, investor appetite to borrow ETFs has increased, contrasting the falling percentage of stock on loan for US large cap companies. Augusts’ spike in borrowing demand for US large caps could spell a more pronounced move by hedge funds to express a directional view rather than hedge their long exposure via ETFs
 

Bottom line

Hindsight is without doubt a wonderful thing and it is easy to point the finger towards the hedge fund community for driving August’s market turbulence. Yet it seems they were positioned for growth and did not anticipate the extent macro economic uncertainty would trample over stock prices, despite the strong corporate earnings season. Having reacted to the market correction, it will be interesting to see whether hedge funds express a greater desire to go short and whether this will ever approach the levels seen prior to the Lehman crash. Somehow I doubt it.