Most shorted index retraces, teasing a market bottom

Chart down
Pablographix | Getty Images

The potential demise of a multi-year bull market in stocks may have brought the bears out of hibernation, at least by one technical measure.

The Thomson Reuters U.S. Most Shorted Index, which tracks the performance of U.S. stocks with a large accumulation of bearish bets against them, is a makeshift benchmark of how long or short the market is.

As it happens, the index has fallen over 13.5 percent this year, and is now down a whopping 45 percent from a 2014 high. Currently, the Reuters benchmark hovers at the lowest levels since the index's origination in early 2013, which coincides with the market's big move to the upside this week.

"It has acted as a sort of "canary in the cave" many times over the past couple of years, as it seems to detect uneasiness even before the broader markets do," said Phil DeFrancesco, the creator of the Most Shorted Index and head of Thomson Reuters' global equities desktop division.

"This Index is showing that investors have been getting increasingly uneasy for a few months before the recent selloff," he added. DeFrancesco noted that last year, just before blue chips rallied to their highs, the Most Shorted benchmark "severely" underperformed.

The index's performance compares to the broader S&P 500 Index, which is down 6.7 percent year to date, and is about 10 percent from an all-time high set in May last year.

The Reuters index consists of U.S. names that have the highest short interest, filtered by market capitalization and stock price. Using the news and information service's proprietary model, the names are ranked by short interest ratio, while the top 50 names picked as index constituents.

Investors use the Reuters index to gauge the bearish sentiment in weak stocks, along with insight into whether any positive news might force short sellers to cover their positions, which often pushes stocks higher.

In a recent re-balancing of the index, 11 different companies were swapped. Some notable names unlucky enough to be added to the index, including Twitter and CONSOL Energy, are down over 22 percent. Of the most unlucky names, SunEdison has lost nearly 50 percent of its value since joining the index earlier this year.

Other widely known companies in the index include Tesla Motors, JC Penney and Herbalife —all of which are down at least 25 percent from their respective 52-week highs.

Across sectors, consumer cyclical stocks are the most widely represented in the index. Those comprise over 44 percent of total market cap, followed by technology, consumer non-cyclical and financial stocks. Each of those claimed over 18, 10 and 8 percent of total market cap, respectively.

As the market takes a breather in coming days from a continued sell-off, the Most Shorted Index may provide clues to whether the market has in fact temporarily found short-term support, or is preparing for another leg down.