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It's not that the 3% drop from last Wednesday was particularly earth-shattering, mind you; all told, that's a pretty tepid move. Instead, it's the key level that major indices fell through that's cause for concern about this rally's staying power. But short sellers' celebrations could be short-lived in a handful of hated stocks.
That's because, ironically, it's the most hated stocks that stand the biggest shot of a structural pop called a short squeeze. And statistically speaking, the data shows that big, heavily-shorted names are the best to bet
on, not against.
>>5 Earnings Stocks the Bears Hate -- but You Should Love
Going back over the last decade, buying heavily shorted large- and mid-cap stocks (the top two quartiles of all shortable stocks by market capitalization) would have beaten the S&P 500 by 9.28% each and every year. That's some material outperformance during a decade when decent returns were very hard to come by.
When I say that investors "hate" a stock, I'm talking about its short interest. A stock with a high level of shorting indicates that there are a lot of people willing to bet on a decline in its share price -- and not many willing to buy. One of the best indicators of just how high a short-squeezed stock could go is the short interest ratio, which estimates the number of days it would take for short-sellers to cover their positions. The higher the short ratio, the higher the potential profits when the shorts get squeezed.
It's worth noting, though, that market cap matters a lot. Short sellers tend to be right about smaller names, with micro-caps delivering negative returns when the same method was used.
>>5 Stocks Poised for Breakouts
Today, we'll replicate the most lucrative side of this strategy with a look at
five big-name stocks that short sellers are piled into right now. These stocks could be prime candidates for a short squeeze in 2013.