Earlier this week we mentioned the sharp change in short interest over the prior months. I wrote:
Much of the fuel for the 50% rally in the S&P 500 has come from short covering. The general skepticism surrounding the recovery has actually resulted in price gains. But as the rally gets long in the tooth we could be seeing signs that short covering will have a much smaller impact.
The huge declines in short interest are a sign of capitulation in short selling. The bears have been truly slaughtered during this bull run. The change in short interest should be viewed as a contrarian indicator at this juncture. This is also a clear sign of a major change in investor sentiment.
In addition to major changes in short interest, this weeks AAII poll displayed a remarkably bullish reading of 51%. We haven’t seen a reading this high since May 2008 just after the government intervened in Bear Stearns and the market rallied. At the time, everyone was bullish and was declaring that a recession was off the table and a second half recovery was a near certainty. Of course, when everyone is on the same side of the boat, it’s wise to either move to the other side or simply jump off. The bullish side of the trade, in terms of sentiment is incredibly crowded. Positive sentiment can remain high for extended periods of time and can be a major driver in higher prices, however, these environments make for very poor risk/reward scenarios. If any element of doubt or uncertainty creeps into the market we could easily see a sharp and dramatic correction.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.