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JPMorgan sees US$90b of short covering left in US stocks

This Dec 12, 2013 file photo shows the headquarters of JP Morgan Chase on Park Avenue in New York.

[NEW YORK] Here's an awkward fact for anyone attributing the three-week climb in the Standard & Poor's 500 Index to bearish investors unwinding trades: over that stretch, short interest hasn't budged.

That's according to JPMorgan Chase & Co analysts, who compared the amount of stock that traders have borrowed - the first step in a short sale - with the total available at institutions to lend. The level is almost 7 per cent, near a three-year high. Separate data compiled by Markit Ltd. tells the same story: short interest is about 3 per cent of all shares outstanding, roughly the same as at the bottom of the August selloff.

The research is at odds with theories that the only thing driving American equities higher since September has been purchases by traders who got so rich in the meltdown that they were content to take profits. While showing bearish sentiment hasn't dissipated, it also suggests more buying power exists should the pessimists really capitulate.

"What this means is we can reasonably infer that any tailwind from short covering hasn't really been occurring and hasn't been driving the October rally," JPMorgan strategists said. "It doesn't tell you when or to what degree it will happen but it tells you it's not been entirely technical and that's a positive." To bring short interest back to levels before August, short-sellers would have to buy back about US$90 billion of shares, "a clear near term positive for stocks,"  the team led by Dubravko Lakos-Bujas wrote in an Oct 16 report. While short interest data updates slower than the shares are transacted, the ratio of shares on loan to the total number of those available to lending programs indicates short interest isn't subsiding, according to the strategists.

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One reason short sellers may have been loath to part with their trades is that August and September's rout was one of the first times the strategy had worked in years. Hedge funds with a short bias lost 12 per cent over the first five years of the bull market, compared with a gain of more than 200 per cent for the S&P 500.

Thanks to the events of late summer, those funds were up 5.3 per cent in the year through September, data from Hedge Fund Research Inc. in Chicago show. Short interest in S&P 500 stocks stood at 2.5 per cent of shares outstanding as of Aug 6, compared with a two-year average of 2.1 per cent, according to Markit data. At 3 per cent now, the level is near the highest since June 2012, when the benchmark gauge was mired in a 10 per cent decline that lasted more than two months.

Since Aug 25, the S&P 500 is up 8.9 per cent, posting several multi-day advances that were the strongest since 2011. A rally with roots in something other than short-sellers buying back borrowed shares is a good sign for investors and could indicate buyers waiting in the wings, according to JPMorgan.

As stocks climbed in late September, investors pointed to a Goldman Sachs Group Inc. index of the most-shorted stocks as evidence of covering as the gauge surged 9.5 per cent in four days after falling to a five-year low on Sept 29. Still, the group has added 7.3 per cent since then, less than the benchmark gauge's 7.9 per cent advance.

"Often with short covering it's reactionary, and there hasn't been some important catalyst that's come along," Gene Peroni, a fund manager at Advisors Asset Management Inc. in Conshohocken, Pennsylvania, said by phone. "Given there's a little clarity to the Fed not raising rates until next year, oil stabilizing, banking stocks coming up even though earnings are mixed, the indications are there is real buying going on."