Are we seeing the start of a major short-covering rally?

First, we must differentiate the practice of short-selling from investing. It is true that short-selling can be part of an investment portfolio, but typically the practice of short-selling is a trading practice, and that is true even when it is imbedded in a larger portfolio. Therefore, short-selling is a form of trading, typically for short-term profits, and rarely with long-term time horizons in mind.

By that definition, the persons who often engage in short-selling practices are trading with short-term time frames in mind, which means that they are looking for short-term profits. Traders who engage positions like this are also often quick to get out of those positions if the short side of the market suddenly doesn't look as good as it did when they initiated it.

Using the market as an indicator, if a someone sells short the SPDR S&P 500 ETF Trust SPY, -0.15% , SPDR Dow Jones Industrial Average ETF DIA, +0.03% , iShares Russell 2000 Index ETF IWM, +0.89% or PowerShares QQQ Trust, Series 1 ETF QQQ, -0.41% , and that position starts to work for him, but then there is a reason why that position may not continue to work like it did, the typical short seller would be inclined to take profits, get out of the position, and wait for another more ideal entry. Generally speaking, because of the nature of the trade, there are few short-sellers who are actually in it for the long haul.

This short-side mentality can make markets prone to short-covering rallies from time to time. For example, if the market declined aggressively over a short period of time and part of that decline was influenced by the short side of the market, it is reasonable to assume that once the market finds legs, stabilizes, and begins to turn higher, those short positions that were initiated before and which influenced the market lower could rush to cover.

Covering those short positions is exactly what causes a short-covering rally, but it usually takes more than just a little offset to encourage short sellers to exit their positions. Reasonably, because the practice of trading involves faster decisions, deciding to cover short positions can snowball, and if short-sellers begin to cover as a group, they could cause a bid in the market and a rally to ensue.

In many ways, that is exactly what our current market environment is set up for.

The underlying economy is weak, corporate earnings are not likely to be good, global growth rates are horrible, there is a liquidity crisis in terms of new money as that is defined by The Investment Rate (TM), and we are in the third major down period in us history akin to the Great Depression and stagflation, so the problems are not going to go away, but the market has been beaten down recently, and it is ripe for a short-covering rally.