For-Profit Social Psychology

I read a great phrase this week: “Technical analysis is for-profit social psychology”. It’s certainly true that the underpinnings of the best technical indicator is investor psychology. And the reasons to monitor the psychology of the markets make sense, especially if you’re trying to profit from your investments. The trends of investor confidence, as well as the extremes that could reverse them, are what drives the market.

Technical analysis (TA) has many useful tools for tracking investor sentiment. One which we’ll look at today is studying the market participants who are “short”. They are borrowing shares and selling them “short” in the hope that the price will fall before the borrowed shares have to be purchased and replaced. One way to measure this is with Short Interest. Here is a chart of the S&P 500 index ETF (SPY) with the Short Interest in the bottom pane in red.

We can see trends and extremes, but we need to look at all the data to see what we have. Looking at a longer term chart, the measure has grown over time. There are a lot of reasons for this, but the main point is that it makes it hard to compare today with several years ago. See below:

A Better Way

We need something more consistent over time, and even able to compare against other similar securities. For this, we will use the Short Interest Ratio. This is the amount of shares sold short compared to the total tradable shares. Here is the chart of SPY with the Short Interest Ratio in green, reflected as a percentage of the total tradable volume. You can see this range is more stable over time, travelling between just under 1 percent and upwards of 5 percent.

Bearish Stockpiles

We now have a way to measure when the stockpile of bearish positions are increasing or decreasing. Let’s see if we can use this to measure a significant shift in bearish psychology. This could alert us to times that the market might be susceptible. That would certainly be good to know!

We will be measuring the increase in the Short Interest Ratio between readings. This data comes out every two weeks. A big increase in the Short Interest Ratio would imply that something happened over 2 weeks to create more bearish positions.

Now, to be clear, this doesn’t always mean that all participants with bearish positions want the market to go down. There are many sophisticated strategies out there, like hedging, which means taking an opposite position to protect oneself should the market go down.

To measure the change in the Short Interest Ratio, I’ve created an indicator. The indicator is displayed as a histogram, showing the percent change between readings. Green means an increase and red a decrease in the Short Interest Ratio from the last reading. See the middle pane below.

Looking at Extremes

My eye is immediately drawn to that large increase in bearishness. These are the large green spikes in the middle pane on the above chart. There are many that increased more than 50% from the previous reading. I would call 50% a big increase in bearishness! We can start by examining these instances, adding arrows for this condition near the price for easy inspection. See the chart below:

In case you’d like to try this yourself, here is the way to code this up, get started and try your own versions (assuming you have Bloomberg data).

Visually, this measure does a decent job of finding some tops and sideways chop. It doesn’t find all the tops, but what does?

I also want to point out that this isn’t a sell signal. We are just exploring what happens when a very basic measure of bearish sentiment increases.

Since 1993, these 50% increases occurred 21 times for SPY. The average performance of SPY for one month after the 50% increase is the green line in the chart below. The orange line shows the average performance of S&P 500 Volatility Index (VIX) over that same time.

This looks like a first good examination at using sentiment to monitor a market. By that I mean that this avoided some pretty big periods of decline and the market, on average, went nowhere, i.e. not up. And at the same time implied volatility, the price to pay to insure your portfolio, went up 7% on average.

What does that mean in simple terms? When this happened, it shows historically that people are beginning to become twitchy. That might be a good time to be vigilant.

Where Do We Go From Here?

We could refine this idea easily by trying different things with the same data. We could track changes over more than one reading, perhaps a quarter. We could also look at higher or lower percentage changes.

We could even combine this condition of quickly growing Short Interest Ratio with another extreme condition, like overbought. Why not? What about other indexes or even individual stocks? Sure. The sky’s the limit.

Next week, we’ll explore this concept some more. Stay tuned.

Share Link