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| Rallies are "short"-lived: Short sellers may be betting that the latest marrket surge, like other rallies during the past two years, won't last for long. |
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| Investors are divided over whether increased short interest is a bearish or bullish indicator for the market. |
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NEW YORK (CNNMoney.com) – Dare we say it but investors are starting to feel good about stocks again: The Dow is closing on 11,000. The Nasdaq is at a four-and-half year high.
But market bulls may have a reason to be a bit worried. Short sellers, investors who bet stocks are going to fall, have also come out in full force lately. This could raise questions about how much longer the market could keep rallying.
According to data from the New York Stock Exchange, short interest, or the number of shares that have been borrowed and sold short, hit a record for the second consecutive month. Short interest rose nearly 2 percent in November to 8.81 billion shares. Short interest on the Nasdaq hit a record in October and was virtually unchanged in November, dipping less than half a percentage point.
Some investors don't put too much credence in the numbers since a rise in short selling may just be a way for professional investors to hedge their bets, and so not necessarily a bullish or bearish sign.
Jeffrey Saut, chief investment strategist for Raymond James, said one possible reason for rising short interest is the increased popularity of so-called "paired trades" by hedge funds, a practice when an investor buys shares of one company that is doing well, such as say, Toyota Motor (Research), while short-selling a competitor that is struggling, like General Motors (Research).
"There is a lot of noise in the short interest figures," said Saut. "It's a stretch to come to a market investment conclusion or even an inference based on short interest."
What if the shorts are wrong?
But Todd Campbell, president of E.B. Capital Markets, an independent research firm catering to institutional clients, said he thinks short sellers have been increasing their bets lately because this year, every time the market has rallied a bit, it has soon after taken a turn for the worse.
"Short interest is so high because people have been successful this year shorting at the upper end of ranges," Campbell said.
So if short sellers turn out to be wrong, their pessimism could actually wind up having the unintended effect of driving the market even higher.
That's because short sellers borrow stock and sell it, hoping to buy it back later at a lower price and pocket the difference. But if stocks keep heading higher, short sellers may be forced to buy more stock to try to cut their losses, resulting in a so-called short squeeze.
"Very high short interest numbers could be a positive for the market since it suggests this market rally was not expected by bears," said Subodh Kumar, chief market strategist with CIBC World Markets. "If the market has recovered, then people have to cover their short positions, which means there will be more buying power."
As such, Campbell said that investors could make money by betting on stocks that are being heavily shorted because if the shorts are wrong, the resulting squeeze could lift the stocks substantially higher.
Campbell said two stocks he's recommending, partly because of the possibility for a squeeze, are Mobile Mini (Research), a maker of portable storage containers, and healthcare software developer Cerner (Research). Nearly 15 percent of Mobile Mini's available shares were sold short through mid-October, and about 28 percent of Cerner's.
Fight the bears at your own risk
But one fund manager said that rising short interest should not be construed as a contrarian positive sign and that investors should steer clear of stocks that are being targeted by short sellers.
Kevin Gates, co-manager of the TFS Market Neutral fund, which has both long and short positions in stocks, said that individual stocks with a high percentage of their shares being shorted are not wise investments.
To that end, Gates' firm, TFS Capital, analyzed the performance of small cap stocks with varying levels of short interest over the past 10 years.
TFS found that an investment of $100 in a group of stocks with relatively low short interest would now be worth about $1,600 while $100 invested in a portfolio of stocks that were being heavily shorted was worth a little less than $200.
"The theory that short interest is a bullish indicator is fundamentally flawed," Gates said. "There's enough information to prove that for stocks with high short interest, the expected return is lower than for those with low short interest."
With that in mind, Gates said that his fund often looks to short-sell stocks that other shorts have flocked to as well.
Three current short picks in the fund are legal services firm Pre-Paid Legal Services (Research), drug company Bradley Pharmaceuticals (Research) and video game developer Midway Games (Research). More than 30 percent of each company's available shares were being held short through mid-November.
After all, many of the best short sellers have a reputation for doing their homework and pinpointing problem stocks before the rest of the market. That was the case with companies like Enron, WorldCom and Tyco (Research), which were all targeted by shorts before their accounting problems came to light.
"Dedicated short sellers tend to be among the smarter investors on the Street," said Saut.
Will the market keep rallying in December? Click here.
For a look at 2005's stock market turkeys, click here.
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