Bank of America (NYSE:
Cisco Systems (Nasdaq:
have in common? They're all in the clutches of short sellers, and
they are all up more than 10% in the past month.
It's no coincidence. Heavily-shorted stocks are some of the biggest
gainers right now. As short sellers have again learned, even if
you're right in your investment thesis about a particular stock,
the broadermarket can still wreak havoc on your position.
A very confusing summer
You can understand why short sellers are reaching for the Tums
these days. After a decent spring, the U.S.economy appeared to cool
off this summer, joining the rest of the world in what looked to be
an extended period of subpar economic growth. The economic data
have been a bit better in recent weeks, but still paint a dim
picture. Short sellers, anticipating that many companies might be
hard-pressed to meet near-termprofit forecasts, figured it was time
to bet against economically-sensitive companies such as the ones
Yet in the twisted logic ofWall Street , a bad economy has been
good for stocks. Anemic economic growth greatly increases the
chances that the U.S. Federal Reserve will give stocks a boost by
embarking on another round ofquantitative easing (QE) . Past easing
efforts have added liquidity to the economy, which has found its
way into speculative assets, such as stocks. In fact, thirdQE
could be announced as soon as this week asthe Fed is expected to
act, and some may "sell on the news."
The mere anticipation of a third round of quantitative easing is
good enough to get stocks moving up.. Since the first day of June,
for instance, the S&P 500 has risen 12%. That's something the
short sellers simply weren't counting on. And as it has slowly
dawned on them that betting against the market is a losing trade in
the face of imminent Fed action, they're likely looking to cover
short positions. And closing out a short position, by definition,
adds buying power as short sellers need to "buy back"
A more logical autumn?
Yet here's the rub. The Fed's interventions may be able to keep the
U.S. economy from slipping intorecession , but it's unlikely to
give the economy the jolt needed to grow at a robust pace. So in
effect, short sellers are likely to ultimately be vindicated in
theirbearish view -- even if their timing was lousy.
That's why it's important to pay attention to which stocks the
short sellers had been targeting in recent months. Many of their
targets remain vulnerable -- all the more so when you consider the
unanticipated spike that the short sellers have given them.
as an example. As of the middle of August, short sellers controlled
84 million shares of the industrialconglomerate . They figure if
the global economy is in for more challenges in 2013, then GE's
various operating divisions are bound to be negatively affected. As
a result, the company is unlikely to boostearnings per share at a
12% pace (to $1.73), which analysts are currently anticipating. So
these short sellers have been anticipating the company will need to
dampen guidance during one of its upcoming quarterly reports.
But even if that's the case, then short sellers can't help but
notice that shares of GE have been steadily rising since last
December, reaching levels not seen since the start of the 2008
financial crisis. Is the Fed really going to create the conditions
for GE to do more business in 2013? Not likely.
A pair of ramifications
You can glean two takeaways from this short-covering rally. First,
short sellers were likely on the mark with their thesis before, and
once the current euphoria over the Fed's quantitative easing starts
to fade, then stocks like GE may be set up for a short position
that finally makes money.
Even if you're not inclined to have short positions and you are
lucky enough to own these heavily-shorted stocks, then you might
want to look at booking profits. This market has given a real gift
to any investors who have been holdingnet long positions, but you
shouldn't look a gift horse in the mouth.
That 12% gain we've seen in the S&P 500 since early June is
a better gain than can be expected in a typical year, let alone a
typical three-month period. Moving to cash to have fresh ammo for
the next rainy day is often the right move after the market has
posted strong gains. And the heavily-shorted stocks look ripe to
lead up the lost of profit-taking candidates.
Risks to Consider:
As an upside risk, these heavily-shorted stocks could rise even
more if an increasing number of short sellers look to stop fighting
the Fed and cover their positions.
Action to Take -->
The market and the economy have become fairly disconnected. The
market "looks ahead," and in the face of the looming fiscal cliff,
the deepening slump in China, the mess in Europe and the
still-insecure U.S. consumer, it can't count on much of an economic
tailwind in 2013. That's why booking profits on these
heavily-shorted stocks is a sensible move right now.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of CSCO in one or more if its "real money" portfolios.