The election cycle may finally be over, but it isn't the only place that's been negative this fall -- the stock market has been a hate-filled spectacle in 2016. Don't just take my word for it.
In 2016, Total U.S. Market Short Interest, a measure of how many bets are being made on a stock market decline, hit new multi-year highs, indicating that short sellers are piling in at a level not seen since the financial crisis in October 2008. That's a lot of hate for stocks at the same time that the broad market is only about 2% below all-time highs. There's a big disconnect there.
And that out-of-sync dislike for stocks could actually pave the way to big gains in the final stretch of the year. As it turns out, the big stocks that short sellers hate the most also tend to hand investors the biggest returns.
That's not just my opinion -- the data bear it out as well. 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.
But too much hate can spur a short squeeze, a buying frenzy that's triggered by short sellers who need to cover their losing bets to exit the trade.
For our purposes, 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.
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.
Retail giant Target (TGT) - Get Reporthas been flirting with heavy short interest this year. Shares have peeked above a short interest ratio of 10 just three times in 2016, and we're seeing one of those times this fall. That level of shorting implies that it would take more than two weeks of buying pressure at current trading volumes for short sellers to get out of the Target trade. That makes Target a squeeze candidate this November.
Target tips the scales as one of the biggest big-box retailers in the country, with 1,792 locations spread from coast to coast. The firm's target market has historically been right in the middle of the middle market, a focus that's been squeezed in the last couple of years, as most growth has either moved toward luxury retail or to deep discounters. Despite the headwinds, Target still benefits from relatively unique retail positioning today with merchandising that gives it the ability to offer a unique selling proposition besides just being a one-stop shop. Target has long been at the top of the class in higher-margin private label sales -- approximately 20% of sales are Target's own private label products. That's a big advantage over its retail peers.
From a financial standpoint, Target looks attractive here. The firm has put cash to work in the most recent quarter, paying down its debt load. Currently, shares trade for about 13 times earnings, implying a modest discount relative to its other retail peers in a market where valuations remain frothy. Earnings on Nov. 16 could be a short-squeeze catalyst here.
No doubt about it: investors hate shares of car parts company O'Reilly Automotive (ORLY) - Get Report this fall. This stock currently sports a short interest ratio of 10.79 -- at current levels, that means it would take more than two weeks of buying pressure for shorts to cover. It's not totally surprising that short sellers are targeting O'Reilly; in the last three years, this stock's share price has more than doubled, vs. just a 19% price hike in the rest of the S&P 500.
But O'Reilly's ascent isn't looking challenged in 2016.
O'Reilly is the No. 2 car parts retailer in the country, with 4,571 locations spread from coast to coast. The firm has dual sales channels, selling both to do-it-yourself consumers as well as professional repair shops. While many peers are playing catch-up on the professional side of the auto parts market, O'Reilly already has an established base of pro customers that it's able to sell into.
The macro factors are what make the car parts business look attractive right now. For example, the average car on the road today in the U.S. is older than ever before. At the same time, average new car selling prices are climbing. That trend is likely to continue to fuel demand for replacement parts, as consumers try to wring more life out of their cars. Long-term, O'Reilly still has high-margin sales growth ahead.
At a glance, it doesn't look like Paychex (PAYX) - Get Reporthas done much in 2016. Year to date, shares of this payroll stock have gained just 2.46% on a price basis. But that performance stat masks a much more significant rally in shares of Paychex this year. Since bottoming just two weeks into the year, Paychex has handed investors price returns of about 17%. All along the way, short sellers have been feeling the pressure from Paychex's upward price trajectory.
Paychex provides payroll services for more than 590,000 customers, with a focus on small- and medium-sized businesses. The firm helps those smaller firms navigate the maze of tax and compliance issues involved in paying employees, collecting profits in the process. To find growth in recent years, Paychex has also been focusing on expanding its business to other outsourced HR functions, including 401(k) administration and worker's comp insurance. Rising employment numbers have been providing a persistent tailwind for Paychex in recent years.
Another key macro factor that's at play in Paychex is interest rates. Traditionally, under more "normal" rate environments, Paychex has earned substantial income from float interest (the interest money it earns on massive payroll accounts between the time that employers deposit funds and employees cash their checks). With rates held near zero for the better part of the last decade, that revenue stream has dried up. Even a small increase in rates could be parlayed into a big revenue enhancement at Paychex.
Right now, Paychex sports a short interest ratio of 11.57, making it a squeeze candidate this fall.
Digital Realty Trust
Digital Realty Trust is a specialty REIT that owns and manages technology-related properties. The firm owns more than 140 data centers, internet gateways and manufacturing facilities, comprising more than 26 million square feet of leasable space. As a data center REIT, Digital Realty has all the upside from the real estate business, coupled with the gain potential this stock gets from the growing demand for server rack space in the tech sector.
As a commercial REIT, Digital Realty's business involves signing long-term triple-net leases with tenants, an arrangement that takes most of the risks off of its balance sheet. Tenants pay for insurance, maintenance, and property taxes, while paying Digital Realty predictable long-term lease fees. Between that and REIT status that enables the firm to pay out nearly all of its earnings as dividends without being subjected to corporate income taxes, Digital Realty is a purpose-build dividend machine.
And that's where interest rates come into play. In this exceptionally low interest rate environment, high-yield stocks like Digital Realty (which currently yields 3.7%) are fetching premium valuations. With future rate hikes likely to happen as a snail's pace, Digital Realty could enjoy a lot more buying pressure from yield-seekers than short sellers are giving it credit for. All the while, its dividend checks are acting like kryptonite for short sellers. Expect this stock's 25% rally to hold up in 2016. Meanwhile, Digital Realty's short interest ratio comes in at 10.33.
Even if the Ball brand name doesn't ring a bell, odds are you've encountered its products before. Take a closer look the next time you take a swig of your favorite beverage -- there's a good chance Ball manufactured the can. Ball is the biggest maker of metal cans on the planet, with about three-quarters of net sales generated from soda and beer cans. The balance is split between other household packaging products and aerospace components, the latter a business that leverages Ball's expertise in aluminum parts.
Ball has been a company in transition this year. In July, the firm completed a deal to acquire international peer Rexam, a move that meaningfully increased Ball's exposure to international markets. So far, it's too early to weigh the end results of cost savings from the merger; Ball has been cutting duplicated efforts in recent months, but only time will tell whether management meets the $300 million in annual savings that management expects to net by 2019.
The merger was a large driver of the uptick in short interest in Ball, but shorting has only been accelerating following the merger completion. As I write, Ball's short interest has climbed to 18.5, the highest level on our list today. That number implies that it would take nearly a month of nonstop buying for shorts to get out of this trade at current volume levels, making it a prime squeeze candidate. Shares are up about 10% so far in 2016, which means that short sellers may not be as willing to stick it out if shares continue moving against them; buyers look like they're in control of the stock here. Keep an eye out for a short squeeze in November.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.