News Analysis date published New: 
Tuesday, September 11, 2012 - 11:30
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Tuesday, September 11, 2012 - 11:30
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Tuesday, September 11, 2012 - 11:30

How to Turn the Short Sellers' Pain into Your Gain

Tuesday, September 11, 2012 11:30 AM

What do Ford (NYSE: F), Bank of America (NYSE: BAC) and Cisco Systems (Nasdaq: CSCO) have in common? They're all in the clutches of short sellers, and they are all up more than 10% in the past month.

It's no coincidence. Heavily-shorted stocks are some of the biggest gainers right now. As short sellers have again learned, even if you're right in your investment thesis about a particular stock, the broader market can still wreak havoc on your position.

A very confusing summer
You can understand why short sellers are reaching for the Tums these days. After a decent spring, the U.S. economy appeared to cool off this summer, joining the rest of the world in what looked to be an extended period of subpar economic growth. The economic data have been a bit better in recent weeks, but still paint a dim picture. Short sellers, anticipating that many companies might be hard-pressed to meet near-term profit forecasts, figured it was time to bet against economically-sensitive companies such as the ones noted above.

Yet in the twisted logic of Wall Street, a bad economy has been good for stocks. Anemic economic growth greatly increases the chances that the U.S. Federal Reserve will give stocks a boost by embarking on another round of quantitative easing (QE). Past easing efforts have added liquidity to the economy, which has found its way into speculative assets, such as stocks. In fact, third QE could be announced as soon as this week as the Fed is expected to act, and some may "sell on the news."

The mere anticipation of a third round of quantitative easing is good enough to get stocks moving up.. Since the first day of June, for instance, the S&P 500 has risen 12%. That's something the short sellers simply weren't counting on. And as it has slowly dawned on them that betting against the market is a losing trade in the face of imminent Fed action, they're likely looking to cover short positions. And closing out a short position, by definition, adds buying power as short sellers need to "buy back" borrowed shares.

A more logical autumn?
Yet here's the rub. The Fed's interventions may be able to keep the U.S. economy from slipping into recession, but it's unlikely to give the economy the jolt needed to grow at a robust pace. So in effect, short sellers are likely to ultimately be vindicated in their bearish view -- even if their timing was lousy.

That's why it's important to pay attention to which stocks the short sellers had been targeting in recent months. Many of their targets remain vulnerable -- all the more so when you consider the unanticipated spike that the short sellers have given them.

Let's use GE (NYSE: GE) as an example. As of the middle of August, short sellers controlled 84 million shares of the industrial conglomerate. They figure if the global economy is in for more challenges in 2013, then GE's various operating divisions are bound to be negatively affected. As a result, the company is unlikely to boost earnings per share at a 12% pace (to $1.73), which analysts are currently anticipating. So these short sellers have been anticipating the company will need to dampen guidance during one of its upcoming quarterly reports.

But even if that's the case, then short sellers can't help but notice that shares of GE have been steadily rising since last December, reaching levels not seen since the start of the 2008 financial crisis. Is the Fed really going to create the conditions for GE to do more business in 2013? Not likely.

A pair of ramifications
You can glean two takeaways from this short-covering rally. First, short sellers were likely on the mark with their thesis before, and once the current euphoria over the Fed's quantitative easing starts to fade, then stocks like GE may be set up for a short position that finally makes money.

Even if you're not inclined to have short positions and you are lucky enough to own these heavily-shorted stocks, then you might want to look at booking profits. This market has given a real gift to any investors who have been holding net long positions, but you shouldn't look a gift horse in the mouth.

That 12% gain we've seen in the S&P 500 since early June is a better gain than can be expected in a typical year, let alone a typical three-month period. Moving to cash to have fresh ammo for the next rainy day is often the right move after the market has posted strong gains. And the heavily-shorted stocks look ripe to lead up the lost of profit-taking candidates.

Risks to Consider: As an upside risk, these heavily-shorted stocks could rise even more if an increasing number of short sellers look to stop fighting the Fed and cover their positions.

Action to Take --> The market and the economy have become fairly disconnected. The market "looks ahead," and in the face of the looming fiscal cliff, the deepening slump in China, the mess in Europe and the still-insecure U.S. consumer, it can't count on much of an economic tailwind in 2013. That's why booking profits on these heavily-shorted stocks is a sensible move right now.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of CSCO in one or more of its “real money” portfolios.