Don't Miss Out On The Short Sellers' Bull Market

David Sterman's picture

Thursday, October 30, 2014 - 10:30am

by David Sterman

For short sellers, October 22, 2014 may have marked a key turning point: Shares of Lumber Liquidators Holdings, Inc. (NYSE: LL), 3D Systems Corp. (NYSE: DDD) and Cree, Inc. (Nasdaq: CREE), all of which were heavily shorted, fell roughly 10% on the heels of disappointing quarterly results. These stocks had been falling far from their 52-week highs in recent months, and the sharp plunge on October 22 was just icing on the cake for short sellers.

Short sellers are now wondering if it's safe to boost their positions in other stocks on their radar. In the past five years, the rising market managed to lift all boats, creating real pain for short sellers.

The times are changing. The broader stock market may move up or down from current levels -- nobody can say with certainty. The market is becoming more discriminating, and investors can no longer count on bad news being spun in a positive light. Case in point: Both Amazon.com, Inc. (Nasdaq: AMZN) and Netflix, Inc. (Nasdaq: NFLX) delivered uninspiring quarters and they subsequently plunged in value.

These types of stocks had been given a free pass in the past, because short sellers were afraid to bet against them. Now their high valuations are truly seen as a risk in this choppy market. As I noted nearly a month ago, Amazon and Netflix had two of the four highest price-to-earnings ratios in the S&P 500 going into earnings season. Many other stocks noted in that column, which were once untouchable to short sellers, may also soon lose their cloak of invincibility.

With that in mind, here are three other heavily shorted stocks that are being targeted by short sellers. Even long-oriented investors may want to add short positions to their portfolios to provide a hedge against further market downside.

AT&T, Inc.  (NYSE: T)
More than a year ago, I took note of the surging short interest in the wireless services sector. Since then, the short position in AT&T rose to a recent 226 million from 90 million shares, making it -- by a significant margin -- the most heavily-shorted stock on the New York Stock Exchange.

Since my September 2013 look at the company, price wars in this sector have steadily accelerated, crimping profits. That's tough news for AT&T, which will continue to see a steady erosion in its landline business. Now comes word that the Federal Communications Commission (FCC) has "stopped the clock" in its study of a proposed AT&T acquisition of DirecTV (NYSE: DTV). AT&T needs this deal badly in order to keep up with rivals, many of whom are developing broad phone, TV and internet platforms that will, at a minimum, lead to fierce competition. Short sellers anticipate that either the merger won't get approved or that AT&T's core business will continuously deteriorate.

J.C. Penney Co., Inc. (NYSE: JCP)
Hopes for a massive turnaround are beginning to fade for this retailer, as analysts increasingly doubt that sales growth in the next few years will be nearly as robust as management predicts. Though shares have come off of their 52-week highs, short sellers are positioning for even more downside. From the end of September to the middle of October, the short position rose to 96 million shares from 88 million shares, representing more than 30% of the trading float.

A lack of robust sales growth could make it hard for Penney to start making a meaningful dent in its debt load, which recently exceeded $5 billion for the first time. The weak balance sheet is unlikely to strengthen through operating cash flow. As I noted in June, the company so badly under-invested in its stores in recent years that "JCP will need to restore capital expenditures to industry norms over the next few years, eating into any cash flow the company may garner."  Later in that column I noted that JCP may look to clean up its balance sheet by issuing a lot more stock. But the more the stock price falls, the less appetizing that option becomes. If J.C. Penney were to cut debt in half to $2.5 billion, then it would need to issue 335 million new shares, more than doubling the current share count of 305 million.

JetBlue Airways Corp. (Nasdaq: JBLU)
The one-time airline industry upstart appears to be losing its touch. While it has introduced few innovations in the past few years, its larger rivals have merged with each other to create powerful route networks that can more easily link up to new markets. Some of these new routes are cutting right into JetBlue's sweet spot. For example, the carrier profited greatly from early investments in flights to the Caribbean, but "high Caribbean margins are attracting supply (from other carriers)," note analysts at Merrill Lynch. Southwest Airlines Co. (NYSE: LUV) and others have started aggressive expansion plans into some of JetBlue's most lucrative markets and routes.

JetBlue is also suffering from an aging fleet, which is forcing it to spend all of its cash flow on maintenance and plane replacements. All this is happening while the airline industry is operating at a peak. Short sellers, who hold more than 20% of the shares in short accounts, are counting on JetBlue to fall even further behind its peers in coming quarters and years.

Risks to Consider: The biggest risk for short sellers is a bull market that indiscriminately boosts all stocks, though as noted earlier, that phase of the current market seems to have passed.

Action to Take --> It is crucial to track bi-monthly short seller data, not just for potential short candidates, but also to see if a stock that you own is on the list. Short sellers are becoming emboldened, and as they build bigger positions in this choppy market, they could add their own downward pressure on stocks.  Consider the stocks mentioned above for short positions in your portfolio. Of the three stocks profiled here, J.C. Penney appears most ripe for a sharp plunge, especially if sales in the holiday season are subpar.

Now that you have some stocks to short, how about some companies worth going long? Some of the most profitable, stable firms on Earth are those with the highest Total Yield. These are shareholder-friendly companies and their corporate tactics have proven to weather the worst market downturns -- including the dot-com bubble and the 2008 financial crisis. For more information about Total Yield investing, click here.

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.