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Something very interesting has been happening to NVIDIA Corporation’s stock lately – it has been going through what can only be described as a completely natural short squeeze and the end result is that the short interest in NVIDIA (NASDAQ:NVDA) stock has been plummeting sharply. This does not mean that all investors now see it from a bullish point of view; rather that many short investors have taken as much loss as they can stomach and have started to cash out.

Declining short interest on NVIDIA stock could lead to another price hike and increased implied vol

Theoretically, this would mean that the stock will be free to soar even higher as some of its short interest dead weight gets lost. Most of the investors who were short NVDA were hoping for a major correction to reverse the recent bull run back to sub $100 levels. A market correction did happen due to profit taking, but it was nothing more than a few dollars wide and barely corrected the last leg of the run to $106 levels.

NVIDIA Corp. (NASDAQ:NVDA) has increased by more than 224% during the last year to become one of the hottest stocks on S&P. It also had the highest short interest among S&P 500 and there was about $1.5 billion of short interest at the start of last year, and it climbed steadily to $7.1 billion in mid-December stocks. There are two reasons for this, the textbook answer is that such a drastic change in price is usually immediately corrected by the first sell off of investors who bought in before the bull run and want to lock in profits. The second reason for this is that a lot of the investors must have genuinely believed this stock to be overpriced (as we have been saying for well over a year now though, it was underpriced prior to the hike of 2016.).

In 2016, NVIDIA had the highest short interest among S&P 500 stocks with market caps of over $50bn according to Bespoke Investment Group. A rough estimate puts the losses for short sellers at about $4.4 billion last year, according to S3 Partners, a financial analytics firm. The shorts made back about $131 million last week, with the stock falling 4.7% in the first three days of the year. Source: WSJ

Now however, it appears that investors have taken as much losses as they can bear and are cashing out while they can (remember: a short investor faces potentially infinite losses unlike a long investor whose downside is limited simply by invested capital). While this might appear to be another bullish indicator for the stock, and to some extent it kind of is, short interest is very much necessary in keeping the price stable and reliable. In other words, the implied volatility of the stock should increase.

Without a critical amount of short interest, a stock can quickly become irrationally exuberant and prone to pricing bubbles. The SI is basically one of the few things that can keep the exuberance of a stock in check and NVIDIA is no different.

All of these are, of course, technical indicators. If you look at it from a fundamentals perspective, then you really shouldn’t worry about short term stock movements to begin with. The Warren Buffet approach to investment requires that we look simply at the fundamentals of the company, invest and then sleep on it. NVIDIA’s fundamentals have been steadily increasing and in our opinion, the recent bull run was simply the market correcting the price to a level that is more indicative of the company’s new found financial and fundamental strength (thanks to the shift to 16nm FinFET node).

Not only this but as we mentioned before, its automotive strengths and the lack of a Radeon competitor hadn’t really been priced in when the last quarter started and this was something that was bound to happen sooner or later. AMD has shown exceptional performance as well and going forwards into 2017, we should expect to see solid growth in NVIDIA (NASDAQ:NVDA). AMD’s performance will depend primarily on the reception of Ryzen (which we think willbe better than initially expected) while Intel will face turbulent investor sentiment and a potential correction in the face of increasing R&D costs, a hard to manoeuvre company and competition for the first time in quite a few years.