May 7, 2014

Rotation

You’ve heard of 99-year leases?

Karen’s grandfather has had an exceptional lease on life. We were in Nashville last weekend as he marked the calendar a 99th time. Remarkably, in his lifetime headlines have been made by WWI, inventor Nikola Tesla, the Great Depression (he was a divinity student at Yale then) and Adolph Hitler.

Speaking of a lease, in a sense that’s what short volume is. We’re not talking about short interest, periodic reads on short positions outstanding. That metric today struggles for statistical significance. Short volumes marketwide the past 20 days averaged 44%. In our client base, the highest daily average was 63%, the lowest, 28%.

Recently, a noted client received public attention from a prolific Short (an investor who in the old-fashioned way borrows and sells shares to raise cash on a belief exposure can be covered later at a lower cost for an arbitrage profit between selling and buying). In weeks leading up, our client’s volume marked short instead of long (a trade is one of those two, or exempt from the rules, the latter true for less than 1% of all trades so 99% of volume is long or short) rose from 39.9% short daily to 71.9% the day before the news.

It’s hard to fathom so large a portion of daily volume short – leased, or borrowed. Yet consider other assets. Most Americans borrow to buy cars and houses and major appliances. We borrow to buy dinner by paying with credit when we eat out. Banks borrow to make loans today (not generally true before the Fed). Governments borrow for everything. In buying $3 trillion of Treasury bonds and mortgage-backed securities, the Federal Reserve borrowed from Americans’ future earnings and productivity. Borrowing is rampant (and no harbinger of health, but that’s another story).

Stocks are the same save that the ratio still favors owning over renting (at 44% to 56% the divide is no chasm). Tracking borrowing alone tells one little except that your stock’s health is dependent on or derived from borrowing.

Behavioral analytics enrich the data. Classic shorting as practiced by David Einhorn, Bill Ackman and Dan Loeb is only 10% responsible. High short volume often portends rotation – repositioning by investors to treat a stock differently ahead. Say, from growth to value. A stock has appreciated and achieved growth targets, so that investment horizon rotates out, selling to value investors who seek a lower price but longer horizons.

Why does short volume rise beforehand? Perhaps trading intermediaries detect changes in underlying orders that prompt a shift from a long to a short bias. Maybe shorting reflects constrained liquidity. If selling is insufficient to satisfy buying, brokers and traders borrow – which inevitably leads to selling just like rapidly rising real estate prices encourage increased home sales.

There’s a closely related possibility too. The largest securities lenders are passive investors like Blackrock, seeking yield from managed assets. These firms are also recognized data-crunchers. Suppose one trigger for sector or stock-specific rotation is the level of borrowing. Those data would highlight constrained supply and a ceiling on returns from lending.

How to sort one reason from another? Behaviors. If shorting is up but speculative trading and hedging are down, then the driver is neither fast money nor risk-management. It’s likely then a prelude to rotation.

That’s predictive analytics. You can have no better lease on an advantage than knowing a thing before it happens. You can shift from reacting to planning ahead. No moving-average or list of holders offers these clues. And it sure looks cool to management.

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