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Are Hedge Funds Ruining Traditional Sentiment Readings?

Wednesday, May 30, 2007 | 09:00 AM

in Markets | Psychology/Sentiment | Short Selling | Technical Analysis

I love when two articles covering the exact same topic reach directly opposed conclusions.

Typically, its not a case that one is wrong and one is right. More often, when this sort of thing happens, its because one reporter is writing the mainstream or traditional viewpoint, while the other is exploring something new.

The journalistic yin and yang this morning is on a subject we have written about frequently: Short Interest on the Nasdaq and NYSE. Bloomberg and the WSJ each have quite different takes on the subject.

Bloomberg's coverage was straightforward -- and decidely bullish:

"Ultimately you have to cover the short positions and that tends to create more of a buying frenzy,'' said Andy Engel, co- manager of the Leuthold Core Investment Fund, which has outperformed 99 percent of similar funds over the past five years...

James Paulsen, who oversees $175 billion at Wells Capital Management in Minneapolis, expects the S&P 500 to reach 1650 this year, partly because investors betting on declines aren't acknowledging that stocks are cheaper relative to earnings than in 2000 when the Internet bubble popped.

Shares of companies in the S&P 500 trade at an average 17.8 times earnings, compared with 32.8 times at the end of the last bull market, according to data compiled by Bloomberg...

"The last time we were here there was bloody optimism everywhere and enthusiasm about the future, and everything was going to go up,'' said Paulsen, chief investment strategist at Minneapolis-based Wells. "Today it couldn't be any more opposite. It's a pretty good environment."

Compare that with the WSJ's Ahead of the Tape column. It takes a decidely more nuanced view on whether or not this contrary indicator still works the way it used to:

So-called contrarians typically see such bearishness as a reason to buy. The idea is that when investors are down on stocks, expectations are so low that the slightest inkling of good news can send prices higher. In contrast, when investors get too bullish, stocks get priced for perfection, and when perfection doesn't come, stocks decline.

But with hedge funds cutting a much bigger swath in the market, today's high level of short interest doesn't represent the bearishness that it did in the past. Many hedge funds engage in a strategy of offsetting the purchase of shares in one company by shorting another, betting that it will perform worse than the stock of the company that they own. Then there is the booming deals market, which drives merger arbitrage, where investors buy shares of companies set to be acquired and short the acquirers.

Because this short-selling doesn't represent real bearishness, says Bollinger Capital Management President John Bollinger, short interest no longer says much about what the mood of the market is. "Hedge fund activity has destroyed the usefulness of the numbers," he says.

Fascinating stuff!

Sources:
Short Story: Bearish Bets Lose Bullish Bias
JUSTIN LAHART
AHEAD OF THE TAPE
WSJ, May 30, 2007
http://online.wsj.com/article/SB118048148598217838.html

Short Sales Break Record on NYSE; Market Bulls Get More Bullish
Daniel Hauck and Michael Tsang
Bloomberg, May 29 2007
http://www.bloomberg.com/apps/news?pid=20601109&sid=ahMn3AUnD_CY&