One month ago, when looking at the overall level of short interest across the market, we reported that according to JPM, the "most painful part of the short squeeze may be yet to come", and sure enough, aided by an unprecedented amount of central bank intervention, the market has since surged, in no small part due to ongoing covering of short positions.
However, one look at the NYSE short interest data reveals something troubling: there are still many shorts out there.
What is JPM's take? In a note released on Friday night, JPM's Nikolaos Panigirtzoglou has several important observations, the main of which is that CTAs and risk parity funds - which appear to have driven March’s equity rebound - are both significantly overweight equities. As a result he points to figure 2 below as an indication of a "more vulnerable equity market relative to a month ago, with all of the above types of funds currently overweight equities apart from discretionary macro hedge funds which appear to be still close to neutral."
However, "not all shorts are covered. The short base in US equity futures has yet to be covered by spec investors."
He also notes that the short base in S&P500 stocks, i.e. number of shares shorted as % of total shares outstanding, remains elevated and unchanged from its mid February high. Finally, retail investors remain negative and that they sold equity mutual funds over the past two weeks and YTD.
Here is his full take:
The equity market continued to grind higher over the past month driven by further covering of short positions and by CTAs and risk parity funds in particular increasingly their equity exposure markedly intra month. This intramonth swing by CTAs and risk parity funds is best seen in Figure 1 and Figure 2. Figure 1 shows how close the CTA return index has been following the S&P500 index during the second half of March vs. the two indices moving in opposite direction during the first half. Figure 2 goes beyond CTAs and depicts the equity beta of various fund types during the first half of March, i.e. pre- FOMC vs. the second half of March, i.e. post FOMC.
Indeed, Figure 2 shows that it was CTAs and risk parity funds that exhibited the biggest increase in equity exposures intra month. CTAs in particular appear to have switched from a significant short equity exposure during the first half of March to a significant long equity exposure during the second half. Risk parity funds more than doubled their equity beta from around 0.4x to 1.1x. In contrast, balance mutual funds or discretionary macro hedge funds saw little change in their equity beta during March. Discretionary macro hedge funds were flattish before and after the FOMC. Balanced mutual funds, which benefited the most from March’s equity rally, were quite long equities before and after the FOMC meeting. Equity Long/Short hedge funds saw a modest only increase in their equity beta shifting from a rather neutral equity beta before the FOMC to a significant overweight post FOMC.
In all, the picture of Figure 2 points to a more vulnerable equity market relative to a month ago, with all of the above types of funds currently overweight equities apart from discretionary macro hedge funds which appear to be still close to neutral.
But not all of our position indicators have normalized. The short base in US equity futures has yet to be covered by spec investors. The short base in S&P500 stocks, i.e. number of shares shorted as % of total shares outstanding, remains elevated and unchanged from its mid February high (Figure 3).
This year’s previous outflows from equity ETFs have yet to fully reverse, as inflows stalled over the past two weeks. Retail investors sold equity mutual funds over the past two weeks and YTD. And the ammunition from retail investors is even larger than we mentioned a couple of weeks ago. With quarterly reporting funds now available for Q4, it appears that retail investors injected a significant $437bn into money market funds during the second half of 2015. One needs to go back to Lehman crisis to see such accumulation of money market funds. And an additional $16bn was injected into money market funds in the first two months of the year. This previously cumulated firepower could propel equities in the coming months assuming supporting macro and policy news.
In all, the above evidence suggests that not all shorts have been covered. These prevailing shorts are perhaps the reason the equity market has been trading rather short despite elevated equity betas by the hedge fund types of Figure 2. We had argued before that an alternative way to gauge equity market positioning is to examine the response of equity markets to news, where we think of ‘news’ as surprises relative to expectations. In an idealized world, an environment where equity investor positions are heavily long should see equities responding by more to negative news than to positive news. In an environment where investors are short equities, we think the opposite should be happening, i.e. equity prices should be less responsive to negative news and more responsive to positive news.
Over the past six weeks, we had an equal amount of positive vs. negative economic surprises in both the US and Eurozone which in the absence of a position overhang should have been consistent with flat equity markets. Instead the MSCI World Index is up by 10% over the past six weeks.
Figure 5 suggests that the MSCI World index has been more responsive to positive economic news and less responsive to negative news in recent weeks, pointing to overhang of short equity positions. According to Figure 5, the equity market has been trading short since the end of January but this negativity peaked in the third week of February.
In other words, while most program, quant and macro funds are no longer short, the question is whether the momentum higher will spook the last set of net shorts: those traders who remain short spec futures, and retail investors, who are more short the overall market than normal.