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Short Interest, by Victor Niederhoffer

Some recent stocks with large short interests relative to volume ratios as of Nov. 15, ranked by volume of short interest with 245 million for Lucent at the top( but a ratio of just 5) are: CPN 16, XRX 14, HCA 10, GT 10, CHT 320, WIN 27, THC 13, ABS 15, VOD 17, SRP 20, KKD 17, SGI 15, AYE 15.

With the master of bearishness apparently no longer under the weather at the major financial weekly and scheduled to come back next week, one's thoughts turn to such stocks with a view to a study of the predictive properties of this ratio.

Alex Castaldo contributes:

Paul Asquith, then at Harvard and now at MIT, was the author of the famous paper many years ago that claimed that stocks that are heavily shorted under perform in the long run University endowments were enthusiastic about the idea and you predicted that it would not work.

In his latest paper, dated just a few days ago, he qualifies his findings somewhat:

1. The effect shows up for Equal Weighted but not for Value Weighted portfolios, which suggests that it is confined to Small Cap stocks and is absent or reduced for Big Stocks.

2. A new variable, Institutional Ownership, is important. It is the stocks having low institutional ownership which under perform when they are heavily shorted. Asquith explains this by saying that stocks that are heavily owned by institutions are the ones that are easy to borrow/short (presumably the institutions lend the stocks to would be borrowers). When a stock is easy to borrow Short Sales are not a predictor of future returns. But when a stock is difficult to borrow (low institutional ownership) and yet someone goes to the trouble of borrowing/shorting it, THOSE ARE THE ONES that will have low returns going forward. However this situation is uncommon (20 out of 5500 stocks in their sample) and for the majority of stocks short sales are not a good predictor.

3. There are differences on the behavior of shorted stocks on NYSE vs. Amex vs. Nasdaq.

In summary Asquith has moved somewhat towards your position by backtracking partially from his earlier conclusion.

David responds:

Personal experience has led me to the position in which I believe that heavily shorted stocks present an opportunity to longs. Heavily shorted stocks MAY under perform in the long run...but I have seen terrible companies, after being heavily shorted double or triple in price. Conseco is a great example...down to $5, then Ex-GE exec Wendt joins and the stock triples to $15+...the stock DID go bankrupt in the "long run". However, the huge short interest presented an opportunity. It only takes some good news...or a liquidity induced short squeeze...and the owner of a heavily shorted can get bailed out of what may be a terrible company. So as a long of a heavily shorted stock you have two opportunities to be right. 1) short-term squeeze from temporary good news or induced by other means or 2) you are right and the shorts are wrong.

Here comes the broken record...but I made money in OSTK this year because it was heavily shorted (and the company performed well) and have now accumulated a decent position in LVLT... A heavily shorted stock with large blocks held by steady hands of Mason Hawkins, Bill Miller, Walter Scott and others. This area of study is probably one of the important.

One last point on the subject...the market impact of shorting on heavily shorted stocks all things equal results in a lower valuation...perhaps making a potentially good company cheaper than it should be.

Allan adds:

Short selling becomes increasingly attractive the higher the level of interest rates, as the hurdle (how much a stock has to fall to make money) is low because of the interest that can earned on rebated cash. Moreover, at the individual company level, higher interest rates lower net income due to the interest expense line item. Thus the most profitable time to look for short sells should be in environments characterized by high and rising interest rates, and conversely the worst time would be when interest rates are low and falling. We currently have an environment characterized by an interest rate that is below the CPI, and hence negative, suggestive of a poor time for short selling.

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