A positive analyst report sparked a rally in brokerage shares Friday, and sent investors who had bet against the firms racing for cover.

Prudential Securities' David Trone proved that some of Wall Street's embattled analysts can still pack a punch when he upgraded his industry rating on the brokers to market outperform from market perform and lifted his ratings on

Morgan Stanley

(MWD)

,

Merrill Lynch

(MER)

and

Goldman Sachs

(GS) - Get Report

to buy from hold. Prudential has done no underwriting for any of the firms, and Trone doesn't own any of the stocks he has under coverage.

"You kind of have to take a glass-is-half-full view when you see things as bad as they've been," says Trone. Recently improved initial public offering activity will help improve revenues, he says, and murmurs that corporate chieftans are beginning to eye each other's companies augurs increased merger and acquisition activity. Meantime, the stock market's resilience since Sept. 11 suggests that stock trading operations' prospects will also improve.

Obviously there's an element of hope in Trone's forecast, which he freely admits to. "If you wait around for definitive signs on the brokers," he says, "you're going to miss the rally."

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Wall Street seemed to agree with that assessment. Goldman skipped 4.7% higher, Morgan Stanley was up 5%, and Merrill climbed 5.6%. Online and discount brokers, which Trone doesn't even have under coverage, basked in the green glow nonetheless.

E*Trade

(ET) - Get Report

tacked on 10.7%, while

Charles Schwab

(SCH)

went up 7.4%. American Stock Exchange's Broker/Dealer Index climbed 5.1%.

But as much as the gains represent investors embracing Trone's view of things, Friday's pop also reflected the low esteem in which others have long held brokerages. Many have shorted the stocks -- borrowing and selling them under the belief that they can buy them back at a lower price and pocket the difference. From February to December the total short interest in the shares of Morgan, Goldman, Merrill, E*Trade, Schwab and

Lehman Brothers

(LEH)

more than doubled from 48 million to 101 million shares.

Eat My Shorts?
Total Short Interest in ET, GS, LEH, MER, MWD & SCH

Source: New York Stock Exchange

"Why are the brokerage stocks up so much? Because there are a lot of shorts in them," says Jim Volk, co-director of institutional trading at D.A. Davidson. "New money was looking for a reason to buy the brokers, and the magnitude of the moves was exaggerated by the fact that there are all these shorts out there."

It's notable that short interest in these stocks continued to rise even as they recovered from lows following Sept. 11. Apparently few shorts were covering -- buying back shares to return them to their lender -- and many continued to build positions. Trone's note Friday may have convinced some they'd bet poorly. So as the brokerage stocks rose, short coverers were among the buyers. And the rally gathered steam.