Michael Santoli

Market Bulls Have Short Sellers on the Run

Michael Santoli

This year on Wall Street, the bears have been cowed by the bulls.

The relentless rally that has carried stock indexes to new highs while defying all the perfectly plausible reasons for it to falter has predictably gored short sellers – who, as usual, have been massed against a relatively narrow group of expensive or fundamentally suspect stocks.

By most measures, the stocks most heavily bet against by downside speculators and hedgers have risen more than the market as a whole, as an embarrassment of liquidity bathes even pricey and untrustworthy companies in the benefit of the doubt.

Of the 30 stocks with a high short position relative to their share total as of June 28, 12 of them have gained more than 20% year to date and thus have outpaced the Standard & Poor’s 500 index’s 19% rise. Only five of the 30 declined as much as 20% over the same span.

As a group, the 100 stocks in the broad S&P 1,500 index with the greatest concentration of short positions, compiled upon request by Bespoke Investment Group, were up by 22.8% this year through Thursday. That’s a significant four percentage points better than the equal-weighted version of the S&P 500, as gauged by the Guggenheim S&P 500 Equal Weight ETF (RSP).

Some controversial stocks

No surprise, then, that the Ranger Equity Bear ETF (HDGE) – a fundamentally driven short-selling fund – has lost 15% in 2013. Almost all the downside has occurred since early May, as the recent rally back above the springtime highs has been led by more aggressive, volatile and sometimes controversial stocks.

Naturally, this chilly environment for bears has sent plenty into hibernation. The freshest data on short interest won’t be released until late Wednesday, but as of late June the average short stake as a proportion of all available shares was hovering near historic lows at 3.7%, according to Bespoke, even after rising modestly in the June market pullback.

That’s roughly where short interest resided around the last bull-market cycle peak in 2007, and less than half the short intensity evident at the bear-market lows of early 2009.

Along with other indicators of market sentiment (such as historically high margin debt levels and recent upbeat readings from investor surveys) this shows the kind of contentedness one might expect with indexes at never-seen-before heights and the broad perception that the U.S., with its solicitous central bank, offers a warm and cozy home for investor dollars. The thinning of the short base, shrinking one potential marginal source of buying power, is a precondition for an ultimate market correction or worse, but not a sufficient catalyst for one.

Rude treatment of skeptical traders

In just the latest rude treatment of the skeptical trader, cloud-scraping computer-security firm Sourcefire Inc. (FIRE) on Tuesday agreed to be acquired by Cisco Systems Inc. (CSCO) for $76 per share in cash – 25% above its prior all-time high and 180% above where it traded two years ago. The stock even before the deal had skimpy cash flow and a whopping price-to-earnings multiple above 60, drawing short bets to the tune of 18% of all traded shares.

Sourcefire represents exactly the kind of short bait that has hooked and netted downside speculators this year: A highly valued, cult growth stock trading at a huge premium to the market, but perhaps without any company-specific Achilles heel to prompt a comeuppance in a forgiving tape.

Netflix Corp. (NFLX) and Tesla Motors Inc. (TSLA) – perennial catnip for shorts – are perhaps the quintessential “story stocks” that have levitated despite being profoundly expensive relative to demonstrated corporate earnings power, their shares riding momentum and innovators’ mystique more than financial logic.

The professional short seller is popularly viewed as a skeptical investigator of corporate vulnerabilities that might be overlooked by an investor class eager to believe growth stories and tilted in the direction of projecting good things for individual stocks.

Academic research has consistently shown that, over a long span, heavily shorted stocks do tend to underperform the market, and that corporate fraud, accounting irregularities and broken business models are generally sussed out by short sellers before they come to broader attention.

Yet a look at the kinds of crowded shorts that have indeed paid off for the bears this year shows them to be almost entirely made up of macro-driven weakness in basic materials, reflecting the commodity downturn and emerging-markets weakness. Coal company Walter Energy Inc. (WLT), iron-ore giant Cliffs Natural Resources Inc. (CLF), Genco Shipping & Trading Ltd. (GNK) and U.S. Steel Corp. (X) have been huge downside winners.

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Meantime, the mainstay of fundamental short sellers – companies riding widely questioned business models, such as ITT Educational Services Inc. (ESI) and Herbalife Ltd. (HLF) – are up huge.

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One reflection of how this market is failing to reward probity and conservatism is the underperformance of the new (and small) Forensic Accounting ETF (FLAG), which uses quantitative analysis of earnings quality to avoid companies that use loose or aggressive accounting. This year the FLAG ETF has trailed the broad market by more than three percentage points.

This, on some level, is what bull markets do once they’ve been galloping for a while: They penalize prudence and humble the hedged. In the past month or so, parts of the market have been caught up in a “beta binge,” as traders chase after the highest-beta stocks – those that tend to move in most exaggerated fashion in the direction of the benchmarks – to goose performance.

This quickening of the market’s risk metabolism can go on for a good long while when liquidity is plentiful, the economic numbers are “good enough” and investors feel under-exposed to equities. Eventually, though, when overpriced, high-expectation stocks break, they usually break hard, and the time to look for good short opportunities is often right after earlier ranks of short sellers have capitulated to higher prices and fled.

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