Savvy short sellers know to avoid crowds. The best of them will speak of “crowded shorts,” which refer to stocks that are so heavily shorted that they may become vulnerable to a short squeeze that instantly pushes them higher. A number of big-time short sellers have told me they seek to cover their position if they see the crowd piling in to a specific stock.

#-ad_banner-#Some of them must surely be thinking about that right now. The total number of shares held short rose another 6% in just the two weeks ended May 31, to 22 billion shares — the highest level in more than a year. 

These short sellers are also keeping an eye on another factor: the “sideways tape.” This refers to a market that had been moving on one direction but is now moving in a tighter range, or “sideways.” Such a move often leads to a directional market change, as one group (either buyers or sellers) get exhausted and the other group starts to offset and eventually overtake them. 

That’s where you come in. You should be looking for stocks right now that are heavily shorted, yet show promising signs or a turnaround. Why? These will likely be among the first to rebound sharply when the market turns around.

Are we seeing that right now? It’s too soon to call a market bottom, as we don’t know how events in Europe will play out, but it’s increasingly clear that U.S. stocks are finding buying interest as the S&P 500 crosses back above its 20-day moving average.

With that in mind, here are four heavily-shorted stocks that might benefit from a powerful short squeeze.

1. Chesapeake Energy (NYSE: CHK)
Short sellers have had a field day with this stock. The energy producer faces possible cash shortfalls later this year and is saddled with a reckless CEO and an asleep-at-the-wheel Board of Directors. 

The short interest rose from 85 million shares to 95 million shares at the end of May. Yet since then, events have conspired to make short sellers re-visit this crowded short. First, on June 7, Chesapeake sold off more than $4 billion of energy distribution assets (such as pipelines) that not only raises cash but also reduces future capital spending needs by around $1 billion annually. And there may be more asset sales to come. Consider this from analysts at Merrill Lynch: “With asset sales likely to accelerate in coming months, we believe CHK is one of the few companies with a tangible line of sight to closing the gap between the current share price and theoretical Net Asset Value (of $31 a share).” That $31 per share value implies 75% upside for the stock.

Second, Chesapeake’s board recently received a thumbs-down vote from shareholders, boosting the odds of major changes at the top of the company. That move could pave the way for a sale of the company, which would really give short sellers agitation.

2. JC Penney (NYSE: JCP)
Short sellers have been piling onto this retailer. The short position rose 28% in just two weeks to 41 million shares. Yet, as my colleague Adam Fischbaum recently noted, it’s already clear to most investors that the company’s efforts to eliminate sales-based promotions and move to lower every day pricing is not working and will need to be revised. 

JC Penney has already started to sneak some promotions back in, and is now instead focusing on the other pillar of the turnaround: revamping merchandising efforts to imitate the best practices of savvy marketing companies like Apple (Nasdaq: AAPL). Will that strategy work? It’s far too soon to tell, but it seems foolhardy to short this stock now.

3. Hewlett-Packard (NYSE: HPQ)
CEO Meg Whitman has stumbled out of the gate in a bid to get the company back on track. Shares have failed to rise in the nine months since she took the corner office. Sales are likely to fall around 3% in fiscal (October) 2012 to around $123 billion. Short sellers have taken note, boosting the short position a hefty 32% to 47 million in just two weeks.

Yet even with many challenges in front of it, HP is still likely to keep generating solid cash flow, if for no other reason than the fact the company’s workforce is likely to be 20,000 smaller a year from now. As I noted a few weeks ago, HP still stacks up reasonably well compared to rival Dell (Nasdaq: DELL). 

Trading at just five times projected fiscal 2013 earnings of $4.40 per share, value investors may look to snap up shares in a market rebound, causing pain for short sellers.

4. AMD (NYSE: AMD)
I’ve written about this chip maker on several occasions in recent months. Even though shares continue to lag, I still think investors are underestimating the potential of the company’s new Trinity microprocessor. AMD continues to secure new vendor relationships for the chip, especially in the emerging category of ultra-books, which are the PC equivalent of Apple’s MacBook. 

Still, short sellers are predicting trouble ahead even after shares have fallen more than 25% since late March. The short interest rose another 11% in late May to 94 million shares, representing nearly 15% of the trading float. That huge short position would work against short sellers if the market is able to regain its sea legs.

Risks to Consider: A falling market will keep these stocks under pressure, so you need to pay attention to these stocks only when the market indeed looks to have found a floor.

Action to Take –> The market cycles in waves, rising in the fourth quarter of 2011 and the first quarter of 2012, before slumping badly in the current quarter. The current sideways market tells us a change may be afoot, which would be miserable for short sellers — but potentially very profitable for you if you buy one of these four stocks at the right time.

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