Opinion: U.S. stocks will be higher in 12 months — despite Brexit

Opinion: U.S. stocks will be higher in 12 months — despite Brexit
Published: June 24, 2016 12:38 p.m. ET

Study finds a short-interest index, which is currently bullish, has been prescient

By MarkHulbert Columnist

CHAPEL HILL, N.C.—The next 12 months should be good for U.S. stocks.

That cheery prospect would be welcome news at any time, of course, but especially now—given Thursday’s Brexit referendum and the decision by British voters to leave the European Union. Though the S&P 500 SPX, +1.36% was up 3.4% this year through Thursday, for example, it has weathered extraordinary volatility along the way.

This new market indicator is based on the total amount of short selling in U.S. stocks. Short selling is a way in which investors can bet on a decline in prices, and analysts for years have considered the volume of short selling to be a contrarian indicator. In other words, a high level of shorting is bullish and a low level is bearish.

That is an incorrect conclusion to draw from the historical data, however, according to a study that is forthcoming in the Journal of Financial Economics, a respected academic journal.

Matthew Ringgenberg, a finance professor at Washington University in St. Louis and one of the study’s authors, told me in an interview that—when properly interpreted—short sellers actually turn out to be more right than wrong.

Far from doing the opposite of them, therefore, we should be following their lead. And right now, according to Ringgenberg, the volume of total short selling is relatively low.

Why should the average short seller be worth following when the average investor on the long side is not? The reason, Ringgenberg explained, is that the markets place a number of hurdles in front of the short seller that don’t exist for investors on long side. It’s costly to borrow shares in order to sell them short, for example, and it’s not always easy to find borrowable shares in the first place. Short selling is especially risky, since the potential loss is infinite.

It therefore is more likely to really mean something when short sellers clear these hurdles and decide to sell short in large numbers.

British citizens will vote on Thursday whether or not to stay in the European Union. WSJ's Gerald F. Seib explains why the vote to stay or leave may help shed light on the outcome of the U.S. presidential election in November. Photo: AP

In order to convert the raw short-selling data into a single market-timing indicator, the authors of this study had to correct for the long-term uptrend in short-selling volume. This shift is the result of many factors, according to Ringgenberg; probably the biggest is the growth of the hedge-fund industry over the last couple of decades, which has significantly increased the amount of capital devoted to short selling.

Without correcting for this trend, it would look like short sellers in recent years have been markedly more bearish than they were in prior decades. And that, Ringgenberg explained, is just not so.

The index that he and his co-authors came up with measures the extent to which any given month’s short-selling volume is above or below trend. It’s this index that they found to have a superior track record forecasting the stock market’s returns over the subsequent 12 months.

In fact, in back tests, they found their short-selling index had a better track record than any of 14 other market-timing indicators that previous research had identified as showing promise. As you can see from the chart at the top of this column, the current level of the professors’ short-interest index is close to its lowest—and most bullish—level in five decades. It is nowhere near as high—and as bearish—as it was before the 2007-2009 bear market, for example, or in early 1973, right before the severe 1973-74 bear market.

But don’t forget that this new indicator’s forecasting horizon is relatively short—the next 12 to 18 months at most. It sheds no light on the stock market’s longer-term prospects. As I wrote recently in another column, equities’ long-term prospects are modest at best.

But if the message of this new short-interest index is on target, then stocks’ path to an only moderately higher level in 10 years’ time will take the market significantly higher first.

This article has been updated since first being published on Thursday.

For more information, including descriptions of the Hulbert Sentiment Indices, go to www.hulbertratings.com or email mark@hulbertratings.com