After a relentless, if entirely centrally-planned and hence artificial, bull market for the past 10 years, one which has yet to see a 20% in 10 years, it is not a surprise that short sellers, having been hammered week after week, month after month and year after year, have had enough and allowed bulls to have their party. Which is a problem when the rally finally ends and stocks start sliding because while traditionally short covering has been a natural “brake” to any accelerated selloff as the bears cover, when there are no shorts there can be no covering.
We bring this up for the simple reason that with the S&P tumbling again, and on pace for the second worst December in history, many are wondering just when will the shorts step in and provide some deceleration to the increasingly more powerful selloffs.
Unfortunately, as Deutsche Bank strategist Parag Thatte notes, anyone holding out hope for emerging short covering will be disappointed for one reason: the short interest in cash equities (and ETFs) has risen fractionally, but as shown in the chart below remains near its lowest levels since 2010.
As Thatte notes, long/short equity returns were hurt by outperformance of popular shorts in Q2-Q3, and “we see limited appetite currently to outright short stocks/ETFs” following forced short squeezes in the hedge fund community focusing on the “most hated names” in October and November.
In other words, with shorts having exited the market – alongside most carbon-based traders – the pain will only accelerate to the downside without any support for the bulls from short covering, meanwhile emboldened shorts will eventually step in, but not to cover existing positions but rather to establish new ones, adding to the market’s downward velocity.
Finally, adding fuel to the market dumpster fire, a historically low put/call ratio and skew for the S&P 500 also signals limited appetite to spend premium on downside protection relative to upside exposure.
The only good news for the bulls, who are suddenly hurting bigly, is that Long/Short gross leverage has come down sharply in recent weeks, primarily on short covering (hence, why there are no more shorts). Net beta exposure to equities bottomed in mid-November at levels below the bottom after the Q1 selloff but has increased to similar levels since then. This means that while a handful of hedge funds may be forced to liquidate into year end, many will have already done so, and as a result the forced selling observed earlier will likely not escalate into year end.
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