Shorting a stock is considered one of the sexiest and most complex moves on the Street.
Investors are dazzled by stories of hedge fund titans such as David Einhorn and John Paulson raking in billions, going against the grain and taking aim at companies they believe are overvalued or headed for a nose dive.
Take Herbalife (NYSE: HLF) for example. Short interest in the stock exploded higher from 20 million shares in mid-December to an eye-popping 37 million shares in the last week of 2012. This came after it was revealed that a number of billion-dollar hedge funds, led by Bill Ackman, had initiated a massive short position in the multi-level marketing company.
Although that is just one example, there is a very good reason why it is so difficult to short stocks. Historically, the market has spent a lot more time going up than going down. You can see this trend in the chart below, with the S&P 500 up 8,500% since 1950.
Although there can be large discrepancies between the performance of an individual stock and the market, it's important to remember that a rising tide lifts all boats, a factor that supports gains in even the most overhyped and overvalued stocks.
On that note, here is a list of the 10 most-shorted stocks in the S&P 500.
Top 10 Most-Shorted Stocks in S&P 500
While there are good reasons many of these stocks are being shorted, the market is off to a great start in 2013, defying the negativity and skeptics with more gains. And since this bullish trend is a threat to the most heavily-shorted stocks, there's now an opportunity for investors to go long and make nice gains on short squeezes.
Of the 10 stocks in the list above, two stocks are worth considering as top investments -- a homebuilder and real-estate development company because of its strong upward momentum and an online video-streaming provider because of its strategic initiative to move into new markets and redefine its business model.
Here they are...
Lennar Corp. (NYSE: LEN)
There are undeniable signals of a recovery in the housing market, with the S&P/Case-Shiller Home Price Index showing an impressive gain of 3.4% from last year in its latest release.
That has fueled bullish sentiment in Lennar, which jumped an eye-popping 86% in just the past 12 months. Take a look at the chart below.
But with short interest spiking for this stock, it's clear investors think Lennar has gotten ahead of itself. Although the company's forward price-to-earnings (P/E) ratio of 25 is well ahead of its 10-year average of eight, it is directly in line with its peer group.
Looking forward, analysts are projecting impressive earnings growth of 83% in 2013 and 33% in 2014. If Lennar simply holds its current valuation, then this additional earnings growth would lift shares to $56, a 36% increase from current levels.
Netflix Inc. (Nasdaq: NLFX)
Netflix has been on a rollercoaster ride in the past 18 months, topping off above $300 and then crashing down to a little more than $54, before recently rallying back above $100.
The wave of volatility has been driven by a fairly violent implosion in earnings, with analysts calling for earnings of just 40 cents a share in 2013, a huge drop from the $4.75 a share seen in 2011. While this downward pressure in earnings may seem like a deathblow at first glance, there's still good news.
The company is aggressively redefining itself and pursuing highly lucrative, exclusive content deals. It recently inked a deal with The Walt Disney Co. (NYSE: DIS) that includes access to Pixar, Marvel and Disney titles. There's no doubt Netflix is facing an uphill battle against intense competition, but with millions of subscribers, incredible brand recognition and huge short interest, some more good news on the content side of the business could squeeze more shorts and easily push shares back above $100.
Risks to Consider: There is a reason many of these stocks are being shorted. Many are suffering from falling estimates and growing competition. Although the market is on the upswing, a downdraft in the S&P 500 over the debt ceiling would place additional pressure on highly-shorted stocks.
Action to Take --> Shorting stocks is difficult for even the most-skilled and successful investors. And stocks with high levels of short interest are more susceptible to short squeezes, which can send shares soaring. Lennar and Netflix are being shorted for different reasons right now, but with the market climbing higher, even stocks that look overvalued and out of favor can surge in a big way.