Last week we highlighted some indicators that were giving early warning that money managers were preparing for a choppy or volatile market. One of the charts we showed was of an actively managed short ETF (HDGE). We pointed out that it was rising with the S&P 500 Index (SPX). It indicated that traders were putting on short positions in preparation for a market sell off. Now a week later we’re seeing HDGE continue to rise as traders press their shorts. Just what you’d expect when the market starts to sell off.
For clues about the depth and duration of a sell off we like to compare a short of the general market (SH) to an actively managed short fund like HDGE. When the general market is being sold, but shorts are not working it tells us that traders aren’t expecting an extended draw down. It shows that traders are mildly concerned about the market so they want some shorts, but also want liquidity due to their greater fear of the market rising. The September to November 2012 correction was a good example of this. If you look at the chart below you’ll see that SH outperformed HDGE as the market fell. Traders covered their individual shorts as the market fell rather than pressing them.
If you look further back on the chart you’ll see that HDGE outperformed SH ahead of the draw downs in August of 2011 and again in May of 2012. This was evidence of expectations by traders of a longer more sustained sell off. Currently shorts are working which serves as warning that we may see lower prices than most people currently expect. A healthy pull back that doesn’t do much damage to portfolios will most likely see HDGE falling even as SH is rising. A more serious pull back could be ahead if HDGE continues its out performance. Over the next few weeks watch for divergences between the two for an indication of traders expectations.