Oslo, Norway

Traders who bet against the S&P 500 Index reduced their shorts to the lowest levels since February – a strong contrarian indicator that now might be a good time to wager against the broader market.

Since March 9 the S&P 500 Index has rallied 47%.

Short interest on the S&P 500 Index declined to 8.77 billion shares as of July 31 -- a 12% decline compared to two weeks earlier, according to data compiled by U.S. exchanges and Bloomberg yesterday. That’s the steepest drop since September 30.

Investors have sliced their bets against financial stocks the most over this period as they cut exposure by 31%. Financial stocks bottomed on March 6 and have since surged more than 125% off multi-decade lows.

Wagering against the market is a double-edged sword accompanied by massive volatility.

From its highs in October 2007 the S&P 500 Index remains 36% off its best level; but SDS or the Ultra Short S&P 500 Pro Shares ETF, which uses two times leverage, soared 187% from October 1, 2007 through March 9, 2009. SDS has crashed a cumulative 60% since March 9 as stocks have recovered.

Over the last few weeks regulators have slammed leveraged exchange-traded-funds (ETFs) claiming some of these products distort index-linked returns and have banned them in retirement accounts.

Some leveraged ETFs have failed to deliver their implied returns over the last two years; from my experience, however, reverse ETFs have worked wonders since late 2007 augmenting portfolio returns in a crippling market environment. Banning these products is a bad idea.

Like smoking, alcohol or gambling, investors should have the right to choose their own destiny in the marketplace.

Banning reverse or leveraged ETFs is the wrong policy initiative because when markets suffer big losses investors don’t have any other way to protect or hedge assets. IRAs have already been slaughtered in this bear market and should be free to invest in a reverse index ETF under extreme market circumstances.

In late 2007, I created the TSI Chaos Portfolio, which gained just under 22% in 2008. The most profitable constituent in that portfolio was a leveraged S&P 500 Index product that skyrocketed last year, boosting our returns. Without it, our gains would have been far less impressive.

Regulators have banned the wrong products. Investors should be free to choose which products serve their purposes best. If they fail to understand the risks or don’t read a prospectus then it’s their fault; but punishing money-managers and other responsible advisors desperate to hedge their client portfolios is just plain dumb in an age of violent capital markets.

Instead, regulators should focus on the crooks in the investment banking industry that almost destroyed the financial system last year through creative financial intermediation; most of these guys have been bailed-out or paid retention bonuses.

Maybe the regulators should be banned?