The Short Take on Wednesday’s Rally

There are two ways to start a fire. You can take what most would consider the “proper” way by carefully stacking your tinder and wood, lighting a match and then fanning the fire until things really get going.

Then there’s the other way: Throw the wood down, spray it with lighter fluid, add a lit match and back up before you lose your eyebrows.

The united move by central banks around the globe Wednesday morning feels strikingly similar to the second, more haphazard method. The action was like pouring a gallon of gasoline on that wood. Boom goes the market! Unfortunately, as we all know, gasoline fires tend to die out quickly and thus require more attention and effort. The same is likely to be true of the markets in short order.

It’s normal to hear analysts talk about how large market jumps during a bearish trend are attributable to short sellers covering their positions. But the volume from yesterday tells us this was not the case — at least not to a large extent.

Among S&P 500 stocks, yesterday’s volume was heavy, on average about 140% of the average daily volume during the past month (chart below displays daily SPX volume for the last six months). We looked at both ends of the spectrum for short interest ratios within this group (highest and lowest short interest ratios for the SPX names), and the volume for these companies averaged about 150% of the average daily volume over the past month. In other words, the companies with low short interest saw volume to those with high short interest. If the rally were indeed driven by short covering, we would’ve seen disproportionately higher volume on the high short interest stocks.

Given this, we believe that it’s beyond safe to assume that the short sellers likely are adding to their shorts into the market strength. If this is the case, volume will lighten up over the next few days again as buyers step back due to a lack of conviction. This will signal that the market’s recent jump will fade quickly.

With this in mind, it would be foolhardy to jump in with a round of calls given the technical resistance that’s still in place. Monitoring the relatively light volume in the market will be key as it will tip trader’s hands as to whether or not they are committing additional funds from the swelling cache of sidelined cash.