BALTIMORE (Stockpickr) -- The past month and a half has been a good time to be a short seller. As the biggest momentum names on the market roll over, they're leaving some big losses in their wakes. But things aren't as bad as they seem for investors; they're actually worse.
That's because the S&P 500's sideways grind greatly overstates how well stocks are doing in 2014. Since January, the big index is flat, but the average S&P component is actually down 7%.
But I'm not arguing that you should bet against stocks this week. Quite the contrary, in fact.
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Being short stocks is a crowded trade. Short interest for U.S. stocks has risen more than 7.5% year-to-date, and short bets are now at the highest levels we've seen since 2009. Every short interest extreme in the last five years has been a spectacular opportunity to buy stocks again -- but the best upside comes from buying the names that short sellers hate the most.
Over the last decade, buying the most hated and 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. So how do you cash in this month?
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. Too much hate can spur a short squeeze, a buying frenzy that's triggered by short sellers who need to cover their losing bets. And with the S&P 500 within grabbing distance of all-time highs, you can probably guess that there are lots of losing open short bets feeling the squeeze right now.
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.
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 the months ahead.