Where have all the shorts gone?

One big investment bank's internal estimate was that the short positions in the financial stocks alone amounted to nearly $10 billion. There was a view ahead of the delayed opening of trading that the market could bounce as much as 15 per cent as the shorts scrambled to cover their positions. It could have been a classic short squeeze.

Instead the market ended up about 4.3 per cent, coincidentally very similar to the bounce the market experienced last Friday as it became clear the US and UK authorities were starting to impose restrictions on short selling and that the US regulators were developing a structural response to the impact of the credit crisis on their institutions.

That's a solid rise from a weak base, but not the kind of spectacular bonfire of the hedge funds that many had anticipated and some had hoped for.

The bounce on Friday probably provides part of the explanation for why the recovery in our market on Monday wasn't more pronounced. Some of the short covering probably occurred Friday as the actions of the authorities unsettled the hedge funds and injected some fear into equations that previously wildly favoured greed. Until then, with very limited buying support in equity markets, the hedge funds had an almost riskless bet going.

Even with the trading on Friday and Monday, however, one might still have expected something more substantial to have occurred.

Another element of the explanation may be that the gutsier funds have decided to maintain open positions in the belief that the short-covering rally will be short-lived. That strategy would be encouraged by the fact that covered short sales – sales backed by stock borrowed from institutions – didn't previously have to be disclosed.

They could have taken the view that once the hope engendered by the authorities over the past few days petered out, and covering of ‘naked' shorts by funds that hadn't borrowed stock and therefore had to buy to cover had ended, the market would again lack buying support. Given that they wouldn't be easily able to replicate a short position, leaving an existing one running might have some appeal.

Or it may be that some funds decided to avoid trying to jump through the same window of opportunity to cover, recognising that that would only amplify the extent of the rebound, and that their activity will be reflected in buying over the next few days.

What was evident from the trading is that the shorts were where one would have expected them to be – in the larger and more liquid stocks. The larger than average movements were predictably in the financials, the property trusts and the resource stocks.

That tends to provide evidence that the market movement, while it may have owed something to the general sense of relief that the authorities are responding decisively to the crisis, owed at least as much to the unwinding of the short positions.