U.S. Markets open in 5 hrs 27 mins

The 2013 Market Melt-Up Singes Short Sellers

Michael Santoli

“Triumph of the Optimists” is a book chronicling investment returns over a century. But the title also suits the four-month-old 2013 stock market - almost as well as “Bonfire of the Pessimists.”

Not only is the broad Standard & Poor’s 500 index up an impressive 11.6% since Dec. 31, as the once-daunting turn-of-the-year fiscal-policy and consumer-spending risks proved overdone. But the shares of the most heavily shorted large stocks coming into the year have, on average, surged far more dramatically.

The most dramatic instance of naysayers getting burned in a widely disliked stock is Netflix Inc. (NFLX), which had the greatest number of shares sold short at the end of 2012 and the fifth-largest short position in the S&P 500 as a percentage of its freely traded shares.

The DVD-rental and video-streaming player sets off a lot of the usual sparks that get bears agitated – a highly valued stock relative to company profitability, tons of attendant marketing hype, a cult-like consumer following and a high-risk shift to a new business model based on (possibly under-priced) online subscriptions. The stock promptly rode searing subscriber growth and hot programming deals to a 134% ramp in the first four months of the year.

Based on stock-market research firm Bespoke Investment Group’s list of the most heavily shorted stocks as of December, crowding into the skeptics’ favorite targets was like walking into a trap, thanks in part to easy money acting as an upside accelerant to riskier assets this year.

Of the 18 most popular shorts among large- and mid-cap stocks on the Bespoke list, 15 of the stocks are higher on the year, by a stunning average of 44%, or quadruple the overall market’s gain. The three stocks on the list that have dropped the way the shorts were betting – J.C. Penney Co. (JCP), Monster Worldwide Inc. (MWW) and Valassis Communications inc. (VCI) – are down an average of 14.9%.

The unlucky trader who entered 2013 gunning against all 18 of these buzzy shorts would be hurting, as this portfolio has appreciated better than 34%.

Short sellers, who sell borrowed shares that they believe will decline so they might buy them back at lower prices, are generally resented when they’re doing well and mocked while suffering. The world has a long bias, both psychologically and financially speaking, inherently wishing for happy outcomes and higher market values.

The crowded shorts heading into the year ranged across the usual mix of faddish-seeming consumer plays such as Deckers Outdoor Corp. (DECK), Green Mountain Coffee Roasters Inc. (GMCR) and structurally disadvantaged industry plays like Safeway Inc. (SWY), RR Donnelly Corp. (RRD) and Lexmark Inc. (LXK). Yet when financing is cheap enough and the consumer doesn’t roll over as feared, even flawed businesses can win a reprieve. And when their shares are disproportionately targeted by the bears, any bit of non-bad news can provide a lot of upside fuel.

Over the long-term, research has repeatedly shown than stocks with persistently high short interest actually do tend to underperform the market as a whole, implying that short sellers tend to succeed in identifying bad accounting and flawed business models.

Short sellers’ success, though, leans heavily on the relative handful of stocks that eventually go to, or near, zero, as businesses fail or are exposed as frauds. As this year’s results show, trying to wager when a tough business might buckle, in a liquidity-engorged bull market, is a tough game.

On the other hand, patient skeptics might play the flipside of the dip-buying bulls’ record and view the melt-up in roundly shored stocks as a sell-the-rip opportunity.