Last week's late rebound in stock prices provides another opportunity to hedge against significant declines. I wrote last week about why stock prices are vulnerable to declines, particularly small-capitalization stocks relative to large-capitalization stocks. An important reason is the high level of bullishness that sentiment surveys reflect.
Today's report on short selling provides further evidence. Short sales as a percent of all stocks fell to the lowest level, 3.3%, in three years. Though the level of shorting is higher than it was in much of the 1990's, the recent decline in reported shorting corroborates the growing anecdotal sense that the shorts have capitulated and covered their positions during the powerful rally in stock prices since last August.
In addition, individual investors have reversed course after many months of net selling and have been buying equity mutual funds in recent weeks. Though this new buying could drive equity prices higher in the short run, it still seems prudent to hedge portfolios now with put options on stock indexes, or alternatively, to raise cash reserves.
S & P 500: 1320
Russell 2000: 822