A lot of people say that the recent rally in the stock markets is due to a short squeeze, but The Financial Times says that short interest is on the rise along with the markets. A-Train says it’s a sucker rally, but generally a rise in short interest drives the market down, not up.

In addition, the 10-day simple moving average on the Dow Jones Industrial Average is about to cross the 40-day moving average to the upside; the 10-day SMA crossed the 40-day on the S&P 500 Index today. These are buy signals.

Surge in short selling clouds rally prospects

Short interest on the New York Stock Exchange rose to its highest level since the collapse of Lehman during the month to mid-March and at its highest rate in more than a year as hedge funds increased their bets against the rally in US equities during that period.

From February 27 to Friday March 13, the benchmark S&P 500 index rose about 3 per cent, prompting talk among participants of a lasting rally in the US stock markets, which have been battered by the recession.

But over that two-week period, as the equity market rallied, short interest rose to 4.2 per cent of all shares outstanding, up from 3.8 per cent at the end of February.

Short sellers aim to profit from betting on falling stocks prices. They borrow shares and then sell them, hoping to buy the shares back at a lower price, return them to the lender and keep the difference.

The broader stock market rally was eclipsed by several prominent stocks, but short sellers took the view that the gains by these stocks, particularly those most affected by the crisis so far, were unsustainable.

For example Citigroup, which was down 79 per cent for the year to the end of February, rose 19 per cent over the first two weeks of March.

But short sellers appeared to take the view that the gains were unsustainable and increased their short position in the stock by almost five times over that period.

In fact Citigroup was the most shorted stock on the NYSE over the period with a short position of 998.7m shares. The second most shorted stock was Ford Motor , followed by General Electric, AIG and Bank of America.

Borrowing securities to short has become more difficult and expensive in recent times as pension funds and endowments have cut back the amount they lend out to custodians and third-party lenders.

US regulators are pondering the best way to regulate the activities of “naked” short sellers whom many blame for mounting bear raids on companies which can artificially drive down their share prices and even push them to failure.

The largest US stock exchanges earlier this week urged US regulators to adopt a modified version of the so-called uptick rule, originally conceived during the 1930s, which they claim would curb abusive short selling.

The Securities and Exchange Commission considering reinstating the uptick rule after coming under political pressure to take action against short sellers.

The original rule – abolished on July 6, 2007, just as the credit crunch was slipping into high gear – prevented stocks from being shorted unless the last tick in their price was up.

The rule was implemented after the 1929 market crash to prevent short sellers from driving the price of a stock down in a bear run.

By the modified uptick rule the exchanges are proposing that short selling could be initiated only by posting a quote for a short sale order priced at more than the prevailing national bid.

The SEC is scheduled to meet on April 8 to consider proposals for restricting abusive short selling.