An analyst's prediction last week that shares of
could quintuple partly on the strength of short-covering probably should surprise nobody.
"There's still an overhang of the belief that it's a good sign to be long stocks with heavy short positions," says David Tice, portfolio manager of the Prudent Bear Fund. "But it's a game that's dangerous to play, especially in a bear market."
episode is a predictable byproduct of the growing flight to the short side among investors, analysts said, a trend that further clouds the market's already murky waters.
Short on Logic
Short-selling, in which investors sell borrowed shares, hoping to replace them with cheaper ones and profit from a stock's decline, is on the rise. According to the latest data by
, short interest in shares on the Nasdaq Composite Index touched a record high on Aug. 15, up 1.2% from the last report in mid-July. And a look at any recent list of best-performing mutual funds shows a preponderance of shorts.
FreeMarkets, which posted a $241 million quarterly loss in July and has suffered with other business-to-business software makers, has been the locus of a vicious battle between shorts and longs. Its shares are currently about $14.50 each, sharply off its 52-week high of $92.
That's roughly where George Santana of Wedbush Morgan sees them returning when the shorts are forced to close their positions.
"Short interests measured both in numbers of shares and in days trading volume are at the highest levels ever for FreeMarkets," Santana wrote. "This increases the potential that FreeMarkets' shares can rebound strongly and rapidly on potential short-covering on any positive news."
While the spirit of the call -- which also praised the company's fundamentals -- was probably welcomed by FreeMarkets' defenders, others saw less-than-rigorous analysis underpinning the near-term prediction.
"Any analyst who is basing his recommendation or reiterations of stocks on short interest is just totally grasping for straws," says Michail Shadkin, head trader at TraderPulse.com. "You should be basing your recommendations strictly on fundamentals and not looking at what short interest is." Shadkin's portfolio of 22 stocks contains 17 shorts, which largely accounts for its 117% gain since Jan. 1.
Kent Engelke, capital markets strategist at Anderson & Strudwick, says he has made "considerable money" by betting against the shorts. He finds a stock that has a large short interest on it, does a lot of research on the company and buys the shares, "thinking that when the shorts cover, I'm going to make a lot of money."
But the strategist cautioned that short-selling is always a volatile game. For example, Engelke said, many short players lost money when Snapple soared to about $100 from $20 a share on short-covering, after rumors hit the Street that
was buying the brand.
And the recent flood of money to the short side of the market reminds some players of the situation in the late '90s, when investors piled into anything that traded, fueling the stock market bubble. Shadkin, who thinks the market is currently "stretched like a rubber band" and is "oversold on a short-term basis," says today's short-side newcomers "think the market will move lower, no matter what."
Rookies are "just like a lot of silly people, who did silly things and made money on the way up for awhile because the trend bailed them out," says Tice. "The difference is they're with the trend, so they're not going to be shaken as easily."
But Tice says long-time short players know what they're doing, and said an academic study showed that shorted stocks have historically underperformed.
"People who sell stocks short tend to do far better research than people who own them," says Bill Fleckenstein, president of Fleckenstein Capital. "High short interest is usually a warning signal, not a signal to buy them."
But with the market having declined so precipitously of late, there's a growing belief that there's simply less room left to fall, says Giri Cherukuri, head trader at Oak Brook Investments.
"I think going long is less risky," Cherukuri says. "It seems like the market has fallen already, so why short now as it's already low?"