Over the last few months, I have mentioned that short interest seemed to be lower than usual. I have mentioned it in articles and in commentaries to members of my newsletter, The Hedged Alpha Strategy. I didn’t have verifiable proof, but it was just an observation based on looking at short interest as an indicator for many years and from looking at different stocks each week.

Short interest by itself doesn’t provide much insight unless you put it in to some sort of context. The two most common ways of measuring short interest are as a percentage of the float and the short-interest ratio. Short interest as a percentage of the float simply takes the number of shares sold short and divides it by the total number of shares outstanding.

If there are five million shares sold short and 50 million shares outstanding, that 10% of the float sold short. That would be a pretty high percentage and it could serve as a bullish signal in a contrarian manner. If there are 500 million shares in the float, it means only 1% of the float is sold short. That’s a pretty low percentage and wouldn’t garner much attention.

The short interest ratio simply takes the number of shares sold short and divides that number by the average daily trading volume. This tells investors how many days of average trading volume it will take for the short sellers to cover their position should they need to.

Using the example from above, if the stock that has five million shares sold short sees 2.5 million shares change hands each day, the short-interest ratio is 2.0. If the stock only sees an average volume of 500 thousand, that’s a ratio of 10.0. The first ratio is a little low and the second ratio is pretty high. If I was considering a bullish trade on the stock in question, I would be encouraged by a short interest ratio of 10.0. Once again, if the stock rallies like I think it will, short-sellers trying to cover their positions can add buying pressure to a stock that is already rallying.

Personally, I tend to watch the ratios more closely than the short interest as a percentage of the float. The comments I’ve made in articles and commentaries were based on the average short interest ratio being lower than I’m used to. I tend to look at 40 to 50 stocks each week and the long-term average for stocks as a whole seems to run around 3.0. In recent months I noticed that the average seemed to be much lower.

As I stated earlier, I didn’t have quantified evidence that short interest numbers were down, but I found something last week that verified my believes. The chart below is from FactSet and it shows the average short interest as a percentage of the float for S&P 500 members. We see that the percentage is down to 1.5% and it’s the first time since 2000 that the percentage has been this low. I don’t know about you, but when I hear of statistics reaching levels not seen since 2000, it makes me a little nervous.

If we look at the opposite end of the range, the average percentage jumped above 3.5% back in 2009. It appears that the percentage peaked right as the market was bottoming toward the end of the financial crisis. This is a great contrarian indicator—it peaks when the market bottoms and hits its lows when the market is peaking. Does this mean the market is peaking currently? Obviously, we don’t know the answer to that question, but it certainly a reason to be concerned.

The Gap between the S&P 500 and its 52-Week Moving Average

In other research I was performing over the weekend, I took note that the S&P 500 is more than 15% above its 52-week moving average. This is something I have watched over the years, but I had never sat down and quantified the numbers. Over the weekend I put together a spreadsheet of weekly closing prices for the S&P and where that price stood compared to the 52-week moving average. I went back to 1950 with the data.

What I found was that the S&P has been more than 15% above its 52-week moving average for five of the last seven weeks. Looking back in time, the last time we saw the index spend 15% above the 52-week was all the way back in 2010. That stretch extended from September 2009 through the second week of January 2010 and it came after the huge reversal off of the lows in March 2009.

Before the stretch in 2009-2010, you would need to go all the way back to 1999 to find another stretch where the index was more than 15% above its 52-week moving average. There was a four-week stretch in June and July of that year where this occurred.

There were also stretches at the beginning of 1999, there was a stretch in the spring of 1998, and a stretch in the summer of 1997 where the S&P was more 15% higher than its 52-week moving average.

While I wondered whether or not there was a correlation between the index getting too far ahead of its 52-week and subsequent pullbacks, the results I found were mixed. So I don’t think the S&P being so far above its 52-week is a great indicator—at least not by itself.

Congress Could be the Ultimate Contrarian Indicator

When Congress launched a committee to look in to what happened during the big short squeezes, it brought more attention to short selling. Some people are even questioning whether short selling should even be allowed anymore. It was high short interest levels on a few stocks that spurred the investigation and the committee, but in the most ironic way, the low short interest levels should be a bigger concern. It means the overall sentiment toward the market is extremely optimistic—at least from this one indicator.

Now if you combine the low short interest levels with the gap between the S&P and its 52-week moving average, that causes a red flag to go up for me. Now you have Congress meddling in something that most of them don’t really know that much about, and that throws up another caution signal for me.

When extreme reactions are taken from unusual sources, those tend to mark turning points in the market. I remember back in the bear market of 2000-2000, CNBC had a special program to show people how short selling worked and how they could use it to make money. That was in July 2002 if I remember correctly and the S&P would stabilize from July through March 2003, and then it would take off on another bullish phase.

Seeing Congress step in could be a huge sign that the top in the market is near as they try to protect retail investors.

Don’t get me wrong, I’m not suggesting you should rush out and sell every stock and ETF you own, but I am suggesting investors need to proceed with caution. You may want to shift your allocations to lower your equity exposure or take some profits off the table. If you want to protect your portfolio and add some insurance, you can look at adding an inverse ETF. Inverse ETFs go up in value as the underlying index or sector falls in price. There are numerous inverse ETFs and you can find one to represent almost any index or sector.

If you have a well-diversified portfolio of large-cap stocks, the ProShares Short S&P 500 (SH) would be a good fund to add as insurance against a drop in the overall market. If your portfolio has more tech stocks or is made up of more names from the Nasdaq 100, you might want to consider the ProShares Short QQQ (PSQ). Both of these ETFs are straight inverse without leverage. There are double-leveraged and triple-leveraged ETFs for these two indices as well, but the inverse correlation tends to break down over time due to the use of options and futures (derivatives) in order to provide the leverage.

These two ETFs aren’t rated very highly by Tickeron right now, but our platform is more short-term in nature and is looking at daily and weekly indicators. In fact, both the SH and PSQ both have “strong sell” ratings at this time. You are looking to hedge your portfolio for a potential correction that last for months or a bear market that last for a year or so.