Looking through binoculars can give you a clear picture of the specific object you are looking at, but it does not necessarily give you an idea of what the landscape truly looks like. While there have been short squeezes and significant short covering in some names and sectors, the reality is that overall short interest in the market has increased since the major indexes hit their recent lows on June 16.

Looking at the domestic market, which includes U.S. and Canadian listed names (most of the largest Canadian names are dual listed), short interest has increased by $126 billion, or 13.7%, since June 16. The largest increase in short exposure in dollar terms occurred in the Information Technology, Consumer Discretionary and Health Care sectors, while the smallest increases occurred in the Energy and Materials sectors.

Change in Short Interest by Sector

Changes in short interest are made up of the mark-to-market change in the value of the shorted stocks coupled with new short selling or short covering. Looking at short interest, or the dollar value of shorted shares, gives us the actual dollars at risk in the short side of the market, which is not possible when looking at SI % Float. Risk management and limits are dollar based (a 1,000 share or $300k Berkshire Hathaway B short is a riskier position to a portfolio than 1,000 share or $10k Carnival Corporation short). Profit & loss calculations are dollar based (no-one says they crushed a trading day and made 100 shares) and margin and leverage calculations are dollar based (shares may not change but if stock prices change, leverage ratios will fluctuate, and margin calls can occur).

The market has rallied significantly since June 16, with the larger cap S&P 500 up +16.73%, the more tech-based Nasdaq up +22.55% and broader Russell 3000 up 17.60%. These market wide gains increased the mark-to-market value of the shares shorted by $171.2 billion, or +18.64%. The sectors with the largest increase of short interest in dollar terms were the Information Technology, Consumer Discretionary and Health Care sectors while the smallest increases were in the Energy and Materials sectors.

Sectors with the Largest Increase in Short Interest

As the value of shorted shares increase or decrease due to changes in their underlying stock prices short sellers will short more shares, buy-to-cover or stand pat depending on the amount of short side risk they want to take. Overall, short sellers have been actively buying-to-cover as the value of their shares increased – indicating that although they were amiable to an increase in their short exposure the rally had pushed their exposure too for up and needed to be trimmed. Short sellers ended up covering $45.5 billion of their short positions, reducing their short exposure by -4.95%. The largest amount of short covering in dollar terms occurred in the Consumer Discretionary, Information Technology and Consumer Services sectors while the only two sectors with increased short selling were the Materials and Utilities sectors (the Misc. SPAC sector is not an official sector).

Sectors with the Largest Amount of Short Covering

Short sellers have offset over a quarter of the mark-to-market increase of the value of shares shorted. The largest “offsets” occurred in the Consumer Staples, Energy and Communication Services sectors while we saw increased short selling in the Materials and Utilities sectors.

Mark-to-Market Increase in Value of Shares Shorted

While there has been short covering in the domestic market, the short-side has not been reducing their overall short-side exposure to the market. This may indicate that institutions are looking at the recent upward market movements as a “bear rally” and are expecting a pullback in share prices across the broad market if the recession continues or worsens and the Fed is forced to raise rates higher or quicker than expected. But it can also indicate that institutions are building up their long books in anticipation of the rally continuing and the increased short interest is just the associated short hedge growing along with the long side.

The size and breadth of the recent market rally seems to be more than retail buying could support on its own and suggests larger institutional (hedge fund) activity so we may be seeing the smart money getting into the market in size. After missing out on a good portion if this second half rally, institutions may be starting to increase their market exposure in order to make up for the returns they already missed. The increased short interest across all sectors looks more like short hedges to offset beta to increase alpha in a portfolio. We may be seeing a case of institutional FOMO and institutional dollars joining the existing retail buy-side pressure driving up stock prices. The increased short covering would then just be managing short side exposure to maximize alpha and minimize sharp ratios.

Yes, short covering has been helping to drive up the market. No, the institutional side is not deleveraging, they are merely adjusting the tenor of their short book to better hedge a long book that is growing to make up for lost alpha.