Short sellers see major trouble ahead for the U.S. economy and the stock market. We ignore that at our peril.
You might dismiss the short sellers' bearishness because-by definition-they bet on lower prices and therefore are predisposed to seeing the glass as half empty. Actually, however, short sellers' collective bearishness fluctuates widely over time. And right now they are more bearish than they've been in a long time.
You might also try to dismiss the short sellers' current bearishness on the grounds that their behavior is a contrarian indicator. This belief is widespread on Wall Street, but extensive academic research has found that it is wrong. According to several recent studies, short sellers' behavior-properly interpreted-is a better indicator of the market's subsequent 12-month return behavior than almost any other.
The best-known indicator that is based on short sellers' behavior is the short interest ratio, which is calculated by dividing the number of shares currently sold short by average daily trading volume. This metric, also known as the days-to-cover ratio, reflects the number of trading days it would take to cover all outstanding shorts, and is used to compare the intensity of shorting activity over time.
This indicator has limited forecasting ability, however, according to Matthew Ringgenberg, a finance professor at the University of Utah. That's because the short-interest ratio exhibits some long-term, secular trends that have little to do with the market's short-term prospects. In order to zero in on what the short sellers think about the market's near-term prospects, the short-interest ratio must be statistically massaged in order to bracket any long-term trends.
The result of this detrending is what Ringgenberg calls his Short Interest Index (SII). In a study that appeared in the Journal of Financial Economics in 2016, he reported that the SII does a better job of predicting the stock market's 3-, 6- and 12-months returns than a host of other well-known indicators.
The accompanying chart plots Ringgenberg's SII over the last 20 years. It currently stands at 1.66, and you'll notice that there have been only four other times in these two decades in which the index came close to being as high and bearish as it is today.
In retrospect, we can see that market risk was abnormally high on each of these four occasions, though some were resolved in relatively short order. These four are:
In retrospect, I think we can agree that the short sellers on each of these four occasions accurately perceived major downside risk, even if the risk didn't always materialize or was resolved quickly. The government could have defaulted in October 2013, for example, which would have had dire economic consequences. We could have experienced an economic depression in the wake of the COVID-19 pandemic. You don't fault someone for refusing to play Russian roulette, even if we subsequently discover that there was no bullet in the first chamber.
If we take seriously the message of the short sellers, we therefore must conclude that the market is in a very high-risk zone right now. "The lesson of history suggests there are several possibilities," Professor Ringgenberg said in an interview. We could be facing "a short-term blip a la the 2013 possible default or a structural economic downturn a la 2008."
Either way, now doesn't seem the time to throw caution to the winds.
Latest research on the short-interest ratio
Ringgenberg's original research into the SII was conducted nearly a decade ago, so it's worth reviewing more recent studies that have focused on the indicator. Here are two that began circulating in academic circles earlier this year, each of which finds that the SII has continued be valuable-both in the years since Ringgenberg's original research and in many countries around the world:
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com