ETF short interest provides some great insights into what the market really thinks.

I’m going to ignore Matt’s twitter-length rebuttal of my last post, and instead point to an excellent set of data that just appeared in my inbox. State Street Global Advisors publishes (as many firms do) a monthly report on the ETF industry. What grabbed me this time was the short-interest report.

It should come as no surprise that ETFs are heavily shorted. After all, one of the great things about ETFs is that phrase “exchange-traded.” It means you can fold, twist and mutilate an ETF just like you can any other stock, and that means that if you can find it to borrow, you can short it. And since many ETFs are phenomenally liquid, they can be pretty easy to locate for shorting.

Overall, short interest in ETFs as reported on Oct. 15 was 11.84 percent. This is substantially higher than the number for the market as a whole; NYSE short interest was 3.51 percent overall. It’s worth nothing that this is a fairly high historical level for the NYSE—it hovers a bit above 2 percent over the last 10 or so years. Given the recent rally in many segments of the market, I’d actually expect it to be high. But what I wasn’t expecting was the extraordinary short-interest levels in certain sectors of the market:

Let’s cut through the haze here a bit. The “Size: Large-Cap” means the S&P 500 SPDR (NYSEArca: SPY). It is—as of the end of October—the most heavily shorted issue on the NYSE, with some 287 million shares short at the end of October. With some 700 million shares outstanding, this explains the lion’s share of that line item. I was equally unsurprised to see the heavy short position in financials, a figure dominated by the sizable short interest in the Financial Select Sector SPDF (NYSEArca: XLF), or small-cap stocks (explained primarily by a huge short interest in iShares Russell 2000 ETF (NYSEArca: IWM), as they’re up nearly 75 percent from the March lows.

But consumer staples? Consumer staples, most easily tracked by the Select Sector SPDR of the same name (NYSEArca: XLP) or the competitive iShares product (NYSEArca: KXI), has been a laggard in the recent stock market rally. While consumer discretionary stocks have been on a tear, putting that sector up 43 percent in the last year, consumer staples—which includes stocks like Procter & Gamble and Wal-Mart—are up just over 10 percent. From the March lows, of course, all did better, but no matter how you slice it, staples have been a laggard, not a leader.

Granted, you can only call something that has rallied 40 percent a “laggard” with a bit of a wink, but compared with the near-double of consumer discretionary stocks? This surprising bearishness is completely borne out in the options market, where there are 12,611 puts outstanding for November, vs. just 2,759 calls (for a 4.5:1 put/call ratio). By contrast, in XLY, there are 19,471 November puts outstanding to 7,264 calls (or 2.7:1).

Personally, I don’t generally play around with rotating sectors, but this did come as a shock to me. Since ETF shares are destroyed and created based on trading and investment demand, the implication here is that three out of every four shares of XLP exist at the whim of people making negative bets on the sector (of course, those three shares also represent someone else’s long bet, since every short position has an offsetting long somewhere out there.

With all the daily blather about moving averages, double-tops and candlestick formations, this is one indicator I can put some faith in, because it’s a reasonable representation of real traders’ sentiment, and a substantial amount of pent-up purchasing should those shorts decide to cover.