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Are Short Sellers Finally Making Headway?

Posted
12/25/2013 2:00:00 PM
By: StreetAuthority
Referenced Stocks:EPS

Short sellers are wrapping up another tough year, as a liquidity-fueled rally has helped to levitate even the most dubious business models.

Some short sellers have even thrown in the towel, noting that John Maynard Keynes' maxim that "the market can stay irrational longer than you can stay solvent."

But signs are emerging that this losing approach to the market may finally be gaining traction.

In recent weeks, a range of heavily-shorted stocks have indeed begun to move lower, which may be a sign that short selling will again be a useful component of your broader portfolio strategy in 2014.

If you are looking at potential short sale candidates, here are four that are in the targets of short sellers right now.

1. Bank of America (NYSE: BAC )

Shares of this banking giant have rebounded more than 200% over the past two years. Joining its major banking peers, Bank of America finally trades back up above book value, taking away one of the lone pillars of value. That argues for muted upside in the year ahead.

Yet it's the downside risk that is coming into focus as well. In light of the recent wave of multibillion dollar fines levied on rival JP Morgan Chase (NYSE: JPM ) , short sellers think Bank of America is now quite vulnerable. It is now the most heavily-shorted stock on the New York Stock Exchange. The short interest surged 14% in in the second half of November to 134 million shares.

As CNBC recently noted , expectations are building that tens of billions of dollars in fines will soon be levied upon other banks, and no bank is more vulnerable than Bank of America, as it was at the center of many of the fraudulent mortgage practices five years ago.

2. GM (NYSE: GM )

Short sellers boosted their positions in the automaker by a whopping 24% in the final two weeks of November to 107 million shares. It's not simply because shares have doubled over the past two years.

Instead, it's a growing concern that the coming year will be a tougher one for the industry. Dealer inventories are becoming bloated , thanks in part to aggressive manufacturing schedules. Higher inventories threaten to bring back heavy discounting.

Another concern: Ford (NYSE: F ) is gearing up to launch an all new F-150 pickup truck that will make extensive use of lightweight aluminum. Ford's lighter trucks are expected to deliver industry-leading fuel economy, which could lead GM to boost discounts on its recently-launched line of trucks. Ford recently trimmed profit expectations for 2014, and GM's new CEO Mary Barra may be similarly inclined to establish a lower bar for the year ahead.

Make no mistake, GM and Ford are now truly strong companies. These stocks will never again trade down as distressed assets. Short sellers are unlikely to reap big gains, but instead think that this turnaround play is due for profit-taking.

3. Johnson Controls (NYSE: JCI )

One of the most appealing sectors for investors in 2013 has been the industrials. These firms began the year with modest forward multiples and clear leverage to an improving economy. As the year ends, bargains are fast-vanishing. For example, I noted a year ago thata broad restructuring could sharply boost profits for Johnson Controls. Indeed, analysts now expect earnings per share ( EPS ) to surge from $2.66 a share in fiscal (September) 2013 to nearly $4 a share by fiscal 2015.

Trouble is, since my late 2012 profile, shares have doubled, and now trade for more than 12 times projected 2015 profits. That may not seem like a high multiple, until you realize that there are really no signs of a cyclical upturn for Johnson Controls. Sales are expected to grow less than 5% in each of the next two fiscal years.

Short sellers think this stock is quite ripe for a pullback after the solid gains of 2013. The short interest rose a hefty 177% (to 21.5 million shares) in the two weeks ended Nov. 29. Such a big short-term spike is unusual, as short sellers usually tend to slowly build their positions over time. The shorts may be focusing on the growing divergence in fiscal 2015 profit forecasts. A few analysts see EPS approaching $4.25 by then. Goldman Sachs is near the low end with a $3.65 per share forecast. Short sellers may be anticipating lowered forward guidance when results are released in January.

4. Twitter (Nasdaq: TWTR )

As I've noted on a few occasions , this stock began trading on an overvalued basis, and after a recent surge, has become completely disconnected from any sort of fundamental analysis, no matter how far you look out into the future.

Will the euphoria wear off in coming months? Short sellers think so. The short interest spiked 181% in late November, to 17.8 million shares, representing 7% of the float. If the market slumps in 2014, then investors will no longer support "story stocks" and Twitter could fall by half.

Risks to Consider: As an upside risk, a strong start for the markets in 2014 could trigger a short squeeze in these stocks, sending them yet higher.

Action to Take --> When the markets are rising, it pays to bet against short sellers by going long on the stocks they are targeting. In recent years, that approach has reaped big gains as massive short squeezes ensued. But even if the market simply stops rising, then it pays to pivot and ride the herd alongside short sellers. They are a great harbinger of the market's most vulnerable stocks.

The short interest data cited in this article were released on Dec. 10, for the period ended Nov. 29. The December mid-month short figures will be released soon after the Christmas holidays, and you should follow up with these four stocks to see if short sellers are building even bigger positions.