Stocks are near their record highs,and there’s one group of investors who aren’t betting against the market the way they used to: hedge funds.
According to the Financial Times citing data from Markit, shortselling of stocks is at its lowest level since just before the financial crisis began in 2008. Only 2 percent of shares in S&P 500 have been borrowed to short. Hedge funds are generally the big players in shorting stocks.
At first blush, that might seem positive for the markets. After all, fewer sellers should mean higher prices for stocks. But, it may also signal a top; once short-sellers return to the market, there could be trouble.
“It absolutely worries me,” said Steve Cortes, founder of Veracruz TJM. “A healthy amount of skepticism is good for markets. The old adage on Wall Street is that the market climbs the wall of worry. Well, there is really no worrying right now, and that is worrying.”
It’s not just the lack of short selling in the market that concerns Cortes. It’s also low volatility. The CBOE Volatility Index (the VIX), which measures expected volatility in the S&P 500, recently dropped to its lowest level in seven years.
“That is a gigantic warning sign for aregular investor that there is an enormous amount of complacency in the market right now,” Cortes said. “The lack of short-sellers is a very dangerous sign historically.”
Richard Ross, global technical strategist at Auerbach Grayson, is also very concerned with the shortage of short-sellers in the market.
“Hedge funds get paid for performance,” explained Ross, a “Talking Numbers” contributor. “We all think it’s rainbows and unicorns, models and bottles out there. But it’s not easy being a hedge fund manager. If you don’t make money simply, you die. You go out of business. And, that’s why they are covering those shorts because clearly it has not been working.”
Ross believes shortcovering has fueled the most recent leg up in the bull market advance. Looking at a chart of the Dow Jones Industrial Average, he sees signs of a potential top.
While the Dow broke above 17,000 earlier last week, it traded above that level for just two trading sessions, leading Ross to wonder if it was a false breakout. A false breakout often leads to a fast move down, he said, and should that happen, he sees support around the 16,500 level that was previously at resistance. Below that, he sees a second supportat the 200-day moving average, currently around 16,160.
“It’s only 5 percent down from the top; that is a very normal correction,” said Ross. “Of course, I wouldn’t be quite as bearish as I am if I didn’t think we’d go significantly lower from there.”
A 10-year chart of the Dow shows technical symmetry, said Ross, and is the reason why he is so bearish. “I think the decline is going to be deeper than most people anticipate,” he said
After breaking above its 200-day moving average in early 2004, it took the Dow three years and 11 months to reach its peak. The index subsequently broke below the 200-day moving average during the financial crisis in 2008. It has been three years and 10 months since the Dow finally broke above its 200-day moving average again. The average is currently at 13,585.
“If history repeats itself, which it often does, we are on the precipice of a very sharp decline,” Rosswarned.
To see the full discussion on the Dow Jones Industrial Average, with Cortes on the fundamentals and Ross on the technicals, watch the above video.