While the S&P 500 was racking up a 30% gain in 2013, short selling was a very unwise strategy. Even in the first six months of 2014, the rising market made a mockery of bearish investing.
Yet over the past six months, as the market slowly began to move sideways, short sellers finally started to gain traction. And if the market makes only modest gains in 2015, short selling is likely to become an increasingly important arrow in the investing quiver, even for those investors that typically shun this seemingly risky strategy.
That price chart explains the simple and powerful appeal for short sellers: the market falls a lot faster than it rises. Said another way, when the market dropped roughly 7% (peak-to-trough) in October and around 5% in mid-December, stocks with a high beta -- especially those with high short positions -- fell to an even greater extent.
For short sellers, success breeds confidence, and they appear to have had a successful year in 2014. The 112 stocks with the highest short position fell roughly 17% (as of December 12, 2014), according to a recent article in the New York Post. Much of those gains likely came in the second half of the year when the market was no longer squeezing short sellers into covering their positions.
Let me cite a few examples.
3D Systems Corp. (NYSE: DDD) began 2014 making a fast approach for the $100 mark, peaking at $97 in early January. At the time, roughly 2.5 million shares were held short. For a stock with more than 100 million shares outstanding, that's not a large number, even though 3D Systems appeared to have a number of red flags on its accounting statements.
Yet with each passing month in 2014, its shares fell in value, the short interest rose and eventually approached 10 million shares by mid-year. As shares collapsed further in the final four months of the year, the short interest kept rising (to a recent 16 million) as shares moved below $35.
In a similar vein, gun maker Sturm, Ruger & Co., Inc. (NYSE: RGR) began 2014 on a high note, as its shares moved above $80. At the time, the short interest had mostly remained below 10 million shares. As its shares started to move toward $65 this summer, shorts became emboldened and the short interest increased to more than 20 million shares. The stock eventually fell to a recent $35, and short sellers appear to have booked some profits, as the short interest is back down to around 11 million shares.
Of course, these kinds of hindsight examples may seem to be cherry-picking, but the basic point remains: if an individual stock -- or the broader market -- appears to have lost upward momentum, then short sellers have a much better chance of succeeding.
This isn't to suggest that the market is likely to fall in value in 2015, only that its non-stop ascent is likely a thing of the past. Instead, market dips are likely to start appearing on occasion and overvalued stocks will finally be safe to target.
With that in mind, I am focusing on four heavily-shorted stocks that appear poised to reap profits for newly-emboldened short sellers.
AT&T, Inc. (NYSE: T)
This longstanding blue-chip stalwart faces a range of pressures right now, from a merger with DIRECTV (NYSE: DTV) that may not be approved, fierce price wars in its primary business segments and the risk that changes in communications technology and media consumption trends will put the company on a path of slow obsolescence.
That explains why the short interest rose another 9% in just the two weeks ended December 15, 2014, to a stunning 279 million shares. This is -- by far -- the most heavily shorted stock on the New York Stock Exchange. Short sellers are betting that AT&T's foundation will start to crumble in 2015.
General Electric Co. (NYSE: GE)
Shares of this Dow component have managed to stand their ground, even as the company's exposure to the energy sector, Europe and slowing emerging market economies may create real headwinds in 2015. Remarkably, 2015 EPS forecasts have dropped only 2% in the past 60 days (to $1.76 a share), even as the company's end markets have weakened.
Short sellers, who just boosted their short positions by 9% in the most recent two-week period, to around 80 million shares, appear to expect analysts to cut their 2015 views when GE delivers Q4 results later this month.
Walter Energy, Inc. (NYSE: WLT)
This coal miner can't lose money forever. It hasn't turned a profit since 2011 and is expected to lose more than $4 a share in 2015, as coal pricing and demand remain in a funk. Cheaper oil and natural gas surely don't help matters. Money-losing companies eventually go about of business, which is what short sellers are likely anticipating, as they currently control 48% of the trading float.
Taser International, Inc. (Nasdaq: TASR)
This maker of non-lethal stun guns is up an impressive 400% since the summer of 2012, thanks to increasing adoption by police forces.
Yet it's important to understand that sales and profit growth are merely good -- not great. Sales are expected to rise around 12% this year (to around $180 million) and EPS should rise 25% to 30%, to around $0.50 a share.
But shares trade for more than 50 times that projected profit forecast, which explains why Taser's 15 million share short interest position represents 30% of the trading float.
Risks To Consider: The biggest risk for short sellers is the obvious one: If the S&P 500 tacks on another double-digit gain this year, short sellers may need to back away from their positions, perhaps fueling a short squeeze.
Action To Take --> The primary goal of short-selling isn't simply to reap big gains in potentially overvalued stocks. It's real purpose is to provide a hedge in your portfolio, even as much of your money is focused on stocks with upside. Pursuing a short position in a stock requires a higher-than-usual amount on advanced and ongoing research, to be sure that you are not ignoring key factors that may be positive hidden catalysts for the stock.
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