Bears Retreating as Europe Shorts Sink to Seven-Year Low

The retreat by European bears is turning into a rout as equity traders reduce bets against the region's stocks by about $80 billion to the lowest level in at least seven years.

Borrowed shares of Euro Stoxx 50 Index (SX5E) companies, an indication of wagers against equities, have fallen to 1.7 percent of the total outstanding from 3.2 percent two years ago and 24 percent at the height of the financial crisis, according to data from Markit, the London-based research firm. Bullish bets on Europe have reached the most since 2007 in a Bank of America Corp. survey of money managers who oversee $518 billion.

Investors are regaining confidence, squeezing pessimists who say the economy remains sluggish outside of Germany and point to record-low trading volume as a lack of conviction in the Euro Stoxx's 61 percent rally of the past two years. Besides gains in stocks from Banco Bilbao Vizcaya Argentaria SA to Renault SA (RNO), yields on Spanish and Italian bonds have declined to a two-year low compared with German bunds and the euro has strengthened 4.6 percent to $1.35 in the past six months.

"It's called the pain of being wrong," Anthony Lawler, who oversees $6 billion invested in hedge funds at GAM Holding AG in London, said in a phone interview on Sept. 19. "You've had some data in Europe which act as an important signal of a possible bottoming. There are still a lot of risks in Europe for sure, but people believe that those risks are less likely to occur than six or 12 months ago."

Fed Stimulus

The Euro Stoxx 50 rose 2.1 percent last week as the Federal Reserve unexpectedly refrained from cutting monetary stimulus. That brought the advance since equity markets bottomed in March 2009 to 62 percent, trailing the 153 percent surge in the Standard & Poor's 500 Index (SPX) and the 99 percent rally in the MSCI Asia-Pacific Index, data compiled by Bloomberg show.

Gains in European equities suggest the economy, while still sluggish, is healing after the resolve of European Central Bank President Mario Draghi and German Chancellor Angela Merkel helped to ease the region's debt crisis and ended the euro area's longest-ever recession. Merkel won a third term in office after her Christian Democratic bloc took 41.5 percent of the vote in yesterday's election. Shares in the euro area are still cheaper than those in the U.S. or Japan compared with projected earnings, Bloomberg data show.

The Euro Stoxx 50 slipped 0.7 percent to 2,906.35 at the close of trading today.

Emergency Aid

Traders had $165 billion of European equities on loan in September 2011, as the region labored under the debt crisis that forced five nations to accept 496 billion euros ($672 billion) in emergency-aid pledges, Markit data show. Borrowing stock is the first step in a short sale, after which speculators sell the securities in the hope of replacing them at a lower price.

Two years later, after Draghi pledged to do whatever is needed to save the euro, the Stoxx Europe 600 Index has climbed 37 percent while loaned shares have fallen 12 percent to $145 billion, indicating more than $80 billion of short positions have been closed or allowed to expire, the data show.

"If shares are going up and short-sellers were skeptical, you would see more borrowing and more betting against that rise," Karl Loomes, a London-based analyst at SunGard Astec Analytics, a securities-lending data and research company, said in a Sept. 20 phone interview. "Given that share prices have risen and borrowing has remained stable or decreased, it does imply there is a lot more optimism in the market."

Short Interest

Markit's data shows the percentage of shares on loan as of Sept. 13 is hovering just above the 1.5 percent reached Aug. 23. That was the lowest ever in data going back seven years and compares with an average of 5.1 percent over that period.

Mutual funds that buy European equities have attracted $13.1 billion in the past six weeks, according to data from Societe Generale SA and EPFR Global Inc., a research company in Cambridge, Massachusetts. That compares with outflows of $4 billion for funds that buy American stocks.

Investors would need to send about $100 billion to European shares to restore the amount withdrawn since 2007, according to estimates from Paris-based Societe Generale based on data through the end of August.

The Euro Stoxx 50 has returned 61 percent including dividends after sliding to a two-year low on Sept. 12, 2011, data compiled by Bloomberg show. Shares rallied as Draghi, who became the head of the ECB in November 2011, pledged to keep interest rates low and euro-area manufacturing returned to growth following a two-year contraction.

'Stopped Deteriorating'

"There are a lot of reasons why you don't want to be underweight Europe," said Robin Thorn, who helps oversee $70 billion as head of equities at PineBridge Investments LLC in New York. "Things have stopped deteriorating. That doesn't mean that things are great, but they have stopped getting worse."

Europe's debt crisis helped keep both bulls and bears out of the market, according to Stuart Jarvis, who helps manage securities lending at Citigroup Inc. in London. An average of $14.9 billion worth of stock has traded daily during 2012 and 2013 in Germany, the U.K. and France, the least ever, according to data compiled by Bloomberg going back to 2004. The number of Euro Stoxx 50 shares changing hands has dropped 18 percent this year to 710 million a day, the data show.

"There has been a lack of allocation to Europe," Jarvis said in a phone interview on Sept. 19. "In order to put money to work, investors needed a greater degree of certainty. People just didn't like the overall environment in Europe, be it the regulatory angle or the macro uncertainty."

Short Bans

Countries from Spain (GSPG10YR) to Belgium and Italy prohibited short selling during market retreats in recent years. While regulators have lifted the restrictions, traders are still required to report positions that exceed preset levels.

The U.S. and Asia are better investments because European economies are expanding too slowly, according to Julian Lewis at Cavendish Asset Management Ltd. Euro-zone unemployment held at a record 12.1 percent in July and European car sales have slipped to the lowest since records began in 1990, signs that the recovery lacks momentum after the bloc exited a record-long recession in the second quarter.

While yields in Spain and Italy have fallen by more than 3 percentage points from their highs to 4.30 percent and 4.29 percent, respectively, they are still at least 24 basis points above the average rate in 2006, before the financial crisis.

The extra yield investors demand to hold the nations' debt over benchmark German bunds has fallen to less than 2.4 percentage points, the lowest in two years, Bloomberg data show. Draghi said on Sept. 16 that the improvement in the euro area isn't fully reflected in the cost of credit.

Little Growth

"Although it looks now as if the euro zone is not going to collapse, we see little signs of growth," Lewis, who helps oversee $800 million in London, said in a phone interview on Sept. 18. "Despite the recovery in Europe, we don't see as much upside there as we see in emerging markets and the U.S."

Europe's economy helps make the ECB's commitment to loose monetary policy more credible for investors, who have been skeptical of pledges of long-term easing from the Fed and the Bank of England, Pierre Lapointe, the Montreal-based head of global strategy and research at Pavilion Global Markets Ltd., wrote in a Sept. 17 report. The key interest rate in the euro area is 0.5 percent, compared with 0-0.25 percent in the U.S. and 0.1 percent in Japan.

"The European Central Bank could step in if needed," said Nicolaas Marais, who helps oversee $327 billion as head of multi-asset investments and portfolio solutions at Schroders Plc in London. "There are some signs of economic stabilization and portfolio rebalancing from the U.S. and emerging markets to Europe. All in all, it's too much for shorts to bet against."

Investor Allocation

ECB support may be helping attract investors. Thirty-six percent of respondents in a survey this month by Charlotte, North Carolina-based Bank of America said they hold more euro-area equities than are represented in global benchmarks, the highest level since May 2007, when the subprime-debt crisis began. A year ago, they reported the smallest allocations to the region relative to the rest of the world, the survey showed.

"In today's prolonged bull market, it has been hard for short sellers to bet against a rising tide," said Will Duff Gordon, the research director at Markit in London. "The muted borrowed demand today is the new reality."

Borrowed stock in BBVA (BBVA), Spain's second-biggest bank, has fallen to 0.23 percent of the Bilbao-based company's outstanding shares, from 2.41 percent two years ago, Markit data show. The stock surged 41 percent in the period.

Renault Borrow

Loans of shares on Paris-based Renault, France's second-largest carmaker, account for 0.92 percent, down from 2.25 percent in 2011 as the shares more than doubled, the data show. Stock on loan in Siemens AG (SIE), Europe's largest engineering company, has declined to 0.78 percent of shares outstanding from 3.2 percent two years ago, Markit data show. Shares of Munich-based Siemens climbed 33 percent in that time.

Euro-region stocks are cheaper than equities in the U.S. and Asia. After an 11 percent gain in 2013, the Euro Stoxx 50 trades at 13.1 times projected earnings, according to Bloomberg data. The S&P 500 is valued at 15.5 times estimated profit and Japan's Topix (TPX) trades at 15.1 times income after Prime Minister Shinzo Abe vowed to end two decades of deflation.

Valuations in Europe will climb over the next 12 to 18 months amid rising appetite for risk, Anna Esposito, an equity strategist at Citigroup in London, wrote in a Sept. 16 report. She forecast that the Stoxx 600 will rise to 370 by the end of 2014, 18 percent above last week's close.

For Julio Sobremazas, the Madrid-based head of global equities at BBVA, the closing of short bets on European shares is a positive sign for the market.

"What you have seen is all those underweight positions, and there were many, being closed and moving to neutral," Sobremazas said in an interview. "We now need to see people committing money."