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Monday, January 13, 2014 - 14:30
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Monday, January 13, 2014 - 14:30

As The Market Rally Cools, Which Stocks Are Short Sellers Circling?

Monday, January 13, 2014 2:30 PM

One of the unremarked themes of the great bull market of 2013 was investors' surging appetite for risk.

Stocks that were already trading at rich valuations caught fire, sometimes pushing their valuations into nosebleed territory. Case in point: Twitter (NYSE: TWTR), which surged from $40 in late November to more than $70 a month later.

Who would have the nerve to go against such a powerful run by selling shares short? Plenty of investors, as it turns out. According to short interest data released Jan. 10, the short interest in Twitter surged 24% in the two weeks that ended Dec. 31, to 29.4 million shares.

The fact that shares have already plunged more than 20% since Christmas has likely emboldened short sellers to hike their positions further. Ratings downgrades from Morgan Stanley and Cantor Fitzgerald, along with bearish new coverage from Cowen, surely helped the short sellers with their cause.

But these shorts are likely stepping up their positions for another reason: In a matter of weeks, Twitter will deliver fourth-quarter earnings and issue a 2014 outlook. The company is facing an extremely high set of expectations, and anything less than a blowout may lead still-bullish investors to take profits. (Twitter may also look to issue a secondary share offering, which typically leads to some short covering, making this a trickier short than most.)

Twitter has company. Facebook (NYSE: FB), for example, saw its short interest spike from 32 million shares in mid-December to 41.7 million at year's end. Recall that Facebook delivered a very strong set of second-quarter financial results, which led to robust share price gains.

Although Facebook also topped third-quarter estimates for earnings per share (EPS) by more than 30%, the investor reaction was not the same. Short sellers may now be convinced that unless Facebook once again delivers stellar quarterly results, shares will face renewed pressure.

Analysts at Pacific Crest Securities also think that Facebook's upcoming earnings report may reveal longer-term concerns. They think Facebook "has likely entered a period of (1) declining ad impressions, (2) softer engagement, and (3) greater spending." They add that "there is now no consensus 'wall of worry to climb,' at a time when we believe the near-term catalysts could be overhyped (namely, video and Instagram)."

Storage Revolution
Beyond earnings season, short sellers also identify other factors that may pressure a stock, including rising competition.

Over the past 12 to 18 months, a number of young startup companies are gaining serious traction in the field of data storage. Companies such as Pure Storage, Actifio and Nimble Storage have plans to go public soon, or have already done so, and each aims to take a slice of market share from storage giant EMC (NYSE: EMC).

The rising competition may explain why the short position in EMC surged 29% in the final two weeks of December, to 117 million shares. That makes it the fourth most heavily shorted stock on the New York Stock Exchange (behind AT&T (NYSE: T), AMD (NYSE: AMD) and Alcoa (NYSE: AA)).

More fodder for shorts: EMC's storage niche is no longer growing at a robust pace. Merrill Lynch analysts recently noted that "EMC's networked storage revenue growth decelerated for the 9th consecutive quarter" in last year's third quarter. They see more signs of deceleration ahead: Though the consensus forecast for EMC's 2014 EPS has already drifted down from $2.11 to $2.04 over the past 90 days, Merrill's analysts now expect 2014 EPS of around $1.95 a share.

A 3-D Printer For Medicine
Swept up in the 2013 frenzy for 3-D printing companies, Organovo (NYSE: ONVO) has been captivating investors' interests with its purported ability to create human tissue with its own printing process. Yet a quick review of recent articles about the company (on Seeking Alpha and elsewhere) suggests the company is more hype than reality.

Short sellers smell trouble ahead. They boosted their position by 30% in the final two weeks of December, to 8.7 million shares, representing 14% of the float. To be sure, the company has strong support from some investors, who think the current $870 million market value is a bargain in the context of an eventual multi-billion-dollar sales opportunity.

But investors should know that this company is likely many years away from ever getting FDA approval. Therefore, Organovo will probably need to keep issuing fresh equity to stay afloat -- and news of a secondary offering often produces the kind of quick drop that short sellers wait for.

Risks to Consider: As an upside risk, an upward move in the stock market through earnings season would cause yet more pain for beleaguered short sellers, and they may look to cover their positions in a short squeeze.

Action to Take --> Even if you're not inclined to short stocks, it's important to track the activity of short sellers. Their moves may prompt you to double-check a bullish investment thesis you have for any company or industry.

P.S. Are you terrible at knowing when to sell? You're not the only one. Fortunately, a former trust fund manager created a two-part blueprint that reveals when to sell... and when to buy. It's been 85% accurate for over four years -- and just closed out a 70% gain. Click here to access it now.

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