Short-sellers hiding as bulls run wild

The seemingly-improbable stock market rally has faced much skepticism, but the bulls have continued to win out, as the S&P 500 ($INX) has now rallied 50 percent from its March lows. With each advance, however, the odds shift slightly more in favor of the bear camp having another day in the sun. And, as David Rosenberg points out, groupthink is one element necessary to push the market too far to an extreme.

Rosenberg, the long-time chief economist at Merrill Lynch noted for his early warnings about the credit and housing bubbles, wrote in a client note that "It does appear that we have some groupthink to consider - virtually everyone at this stage is now bullish on the market... As an example, a CNBC poll released yesterday showed that 90 percent of Wall Street economists believe the recession has ended. It is highly unlikely that 90 percent of the economics community can be right on the same thing at the same time."

Rosenberg added that the recent leg higher is due to short-sellers buying back positions, as the rising market forces them to take losses. "One source of major buying power that may take a bit of a respite is short-covering. Indeed, short interest plunged 10.8 percent in the second half of July; the comparable statistic on the Nasdaq ($COMPX) also fell a sizeable 5.1percent - in just two weeks, but two weeks in which this short squeeze managed to push the S&P 500 up by a whopping 9%." Short selling is the practice of selling shares first, with the intention of buying them back later at a lower price.

Indeed, as Bespoke Investment Group notes, short interest -- or the number of shares sold short at a point in time -- on the S&P 500 is at its lowest point since the end of January. Stocks like Wells Fargo (WFC) and American Express (AXP) have seen their short interest decrease by more than 35 percent, as government support of the financial system has taken worries of systemic collapse off the table. The diminished short interest coincides with the CBOE Volatility Index ($VIX), a gauge of market fear. This index has hit its lowest level since before Lehman's collapse.

Just as short-sellers seem to be on the run, their more aggressive counterparts in leveraged double-inverse, or "UltraShort," ETFs are feeling plenty of pain. The UltraShort series of ETFs aims to deliver twice the inverse of a daily market move, so that a one percent drop in the underlying reference index would result in a two percent gain to the UltraShort holder. Financials and real estate, two sectors that were previously excellent shorts, now show their respective ETFs. The UltraShort Financials (SKF) and the UltraShort Real Estate (SRS) are down 90 and 96 percent, respectively, from their 52 week highs.

Leveraged ETFs have come under fire for failing to track the longer-term returns of their underlying index. Because the ETFs focus on replicating a multiple of the daily move, price changes can quickly compound in ways that leave holders with losses, even if the underlying index acted as anticipated over a longer time frame.

There's certainly an undercurrent of disbelief that the rally is "sustainable." However, that has been the case for more than three months, and many investors have lost money sitting on the sidelines as the S&P 500 has rallied 15 percent over that time. Investors need to be cautious, however, not to believe the great returns of the last several months will continue, or even that the market's rise indicates the general economy is on the mend. Markets move in cycles, and that means the same short-sellers who have been getting squeezed throughout the spring or summer might make a comeback heading into the fall.

James Cullen edits and writes at CollegeAnalysts.com. He has no personal position in the stocks mentioned above.

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