It’s a tale of two markets. 

#-ad_banner-#Value stocks, which are well represented in the Dow Jones Industrial Average and S&P 500 Index remain near all-time highs, while growth stocks, more clearly represented by the Nasdaq Composite Index, appears to be on unstable ground. The Nasdaq index itself isn’t too far from its peak, but many underlying growth stocks have plunged badly during this earnings season.

As an example, the S&P posted around 60 new 52-week highs and 60 new lows last Friday, while the Nasdaq saw 21 new 52-week highs against 139 new lows, a nearly 1-to-7 ratio.

Short sellers are on the case. The latest short seller data, released on May 9 and reflecting short positions through the end of April, show a great deal of macro positioning by short sellers. Their use of exchange-traded funds (ETFs) as proxies for bearish bets is a strong tell in this market. Here’s a look at some key funds, and how shorts are adjusting their exposure.

Broadly speaking, short sellers are boosting their exposure to tech stocks and small caps, while reducing their exposure to value stocks, bank stocks and utility stocks. Some of this is a valuation call: Tech stocks and small caps had become arguably overvalued, and a rotation into stable value plays often happens in the latter stages of an extended bull market.

That doesn’t mean that the bull market is about to end. But it does likely signal that the frothy phases that we typically see in the early years of a bull market have played out. That argues for more muted gains ahead.

You’ll also note a rising short position in a junk-bond ETF. As an economy expands, credit standards start to loosen, and lenders start to issue more dubious bonds. 

Specific Targets
Short sellers have also been boosting their positions in specific companies that they believe to be ripe for a pullback. Their higher short positions often are related to a news-driven event. 

For example, at the end of April, they made Bank of America (NYSE: BAC) the third most heavily shorted stock on the New York Stock Exchange (after AT&T (NYSE: T) and AMD (NYSE: AMD)) on news that BAC had botched a key filing with regulators. BAC’s application to start boosting dividends and buybacks was plagued by a $4 billion error, leading investors to once again ask whether this perpetually mismanaged bank was still worth owning.

If you do want to own a major bank with operational challenges, focus on Citigroup (NYSE: C), which trades for 80% of tangible book value. Even after a recent slide, BAC’s shares trade right at tangible book value.

Mexican cement maker Cemex (NYSE: CX), which saw its short position rise 12% in the final two weeks of April to 90 million shares, is also in the news, but not intentionally. Roughly a month ago, two rivals (Switzerland’s Holcim and France’s LaFarge) announced plans to merge. If the merger goes through, the combined entity will have $40 billion in annual sales, dwarfing Cemex’s $17 billion sales base.

Cemex had a bankruptcy scare back in 2011, when shares slid below $3. The company has managed to modestly reduce its debt load since then, helping shares to rise more than 300%. But the proposed merger by rivals brings the debt concerns right back into the spotlight. 

Short sellers know that Cemex can ill afford a price war, thanks to more than $14 billion in long-term debt that is generating massive interest expenses. Holcim/LaFarge could use its relatively stronger financial resources to price contracts that would really put the squeeze on Cemex.

Short sellers are also tracking the aggressive accounting policies at wireless service provider Sprint (NYSE: S), which saw its short interest level spike 15% in just two weeks, to 74 million shares. Sprint’s first-quarter operating metrics, released at the end of April, appeared roughly in line with forecasts, highlighted by earnings before interest, taxes, depreciation, and amortization (EBITDA) of $1.8 billion. 

Yet Sprint’s numbers are skewed by the fact that the company’s “installment payment plan accounting allows for upfront revenue recognition of handset sales,” which overstates cash flow, according to analysts at Merrill Lynch, who see shares falling from a recent $8.80 to just $5. 

Looking at Sprint’s true EBITDA generation (which will become evident when the near-term accounting shifts are reconciled in future quarters), Merrill thinks that figure is closer to $5.5 billion for 2014, not the $6.8 billion that consensus forecasts infer. And shares look pricey at 11 times that more realistic EBITDA figure.

Merrill sums up its “underperform” rating: “Prior to being acquired, legacy Sprint traded at 5.7 times forward EBITDA and now trades at a higher multiple. The net change in the competitive climate has been negative in the intervening time.”

Short sellers are also increasing their stake in video game maker Zynga (Nasdaq: ZNGA): The short position rose a stunning 34% in just two weeks, to 65 million shares, representing 10% of the float. I highlighted this stock’s overvaluation two months ago on our sister site ProfitableTrading.com, noting that “shares (traded) for almost 20 times projected 2015 EBITDA.” 

Well, that couldn’t last: Shares have lost nearly half of their value since then, thanks to a 36% year-over-year drop in first-quarter sales. Consensus forecasts call for a solid upturn in sales in coming quarters, but short sellers foresee more pain ahead. 

Risks to Consider: If the market shifts gear and moves sharply higher, then these heavily shorted stocks could see a massive short squeeze. 

Action to Take –> Short sellers are likely to step up their game if the growth end of the market continues to struggle. Once-untouchable stocks are now returning to earth, though many of them remain quite lushly valued. That makes this a good time to keep monitoring the actions of shorts, as they may be pointing to the next market blowup.

P.S. An eccentric Texas woman who dodged the 2008 financial collapse says the market is ripe for a pullback. This is the same analyst who’s produced annual returns of up to 510% and has picked winning investments roughly 85% of the time. To learn how she’s protecting her portfolio today, click here.