Kass: How to Short

Avoid stocks that are already heavily shorted. Plus, beware sentiment voodoo.
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As a dedicated short-seller, I incorporate some

basic tenets and disciplines

in my portfolio management.

One of those principles is to avoid hard-to-borrow and heavily shorted stocks.

Yesterday,

Dendreon

(DNDN)

announced that the Food and Drug Administration said its Provenge drug (the first active cellular immunotherapy and the first biologic approved to treat prostate cancer) was safe and that there was "substantial evidence of efficacy."

DNDN has a float of 80 million shares; its average trading volume is about 3 million shares a day. However, short interest totals 20.3 million shares (up nearly 4 million shares from the prior month), or about 25% of the float!

I avoid heavily shorted stocks in which short interest is a large percentage of the float or shares outstanding, such as at Dendreon. To me, high short interest is a nonstarter.

DNDN closed at $5.12 a share on Wednesday (it didn't trade on Thursday) and is currently trading up by over 230% to $17 in the premarket!

DNDN is a classic example of why a short-seller should avoid heavily shorted stocks.

Fundamentals Are Fading Fast

Month-to-date, the

S&P 500

index is up by over 1% in March. It is safe to say (barring an extreme event) that March will likely end up positively, which would put 13 out of the last 15 months in positive territory.

Despite this extraordinary (and historically abnormal) run, at the slightest downtick, I sense a lot of angst in the market by hedge fund operators. From my perch, this means that investors (especially the hedge fund -- and fund of fund -- kind) are far more long (or levered) than most surveys reveal.

Sentiment Studies Are Sometimes Skewed

As I have mentioned previously, I don't put much credence into the various

sentiment studies

, most of which can be subject to, well, very subjective interpretation.

It is my view that, within the context of the investment process, sentiment studies are often simplistic, linear crutches, especially when used in a vacuum.

For example, a lot of the short-interest figures are influenced by structural market changes and the introduction of new securities that require hedges on the other side -- or investors on the other side.

Surveys can also be undependable because they often rely on relatively small samples.

I am aware of instances in which the respondents simply didn't tell the truth or the surveys relied on the bias of advisors or letter writers who "teach" but don't "invest."

Finally, many -- inflicted by a bout of

affirmational bias

-- massage the output to produce a desired outcome (e.g., if you don't like the fact that last week the AAII Bearish percentages have moved to close to a one-year low, change your calculation to a 12-month moving average that doesn't exhibit as much of an extreme reading). You get the picture.

Also Look at Fundamentals

In conclusion, technical analysis plays an important role in the investment mosaic, but making investment conclusions solely by observing squishy sentiment measures can be dangerous to your financial health.

I believe there is far too much emphasis on unreliable sentiment voodoo that can be interpreted any which way and often too little emphasis on economic and company fundamentals (which, by the way, are also open to affirmational bias).

And those fundamentals are fading faster than you can say

Sanjaya Malakar

.

At time of publication, Kass and/or his funds had no positions in any stocks mentioned, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."

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