Stay Away From These Four Heavily Shorted Stocks

By David Sterman

NEW YORK ( StreetAuthority) -- A pretty remarkable shift in sentiment happened in the stock market last month and few may have noticed. The short positions among the most heavily shorted stocks on the stock market shrank by a major amount.

Consider the drop in these short interest positions for stocks that trade on the New York Stock Exchange.

I can't personally recall seeing such a big two-week drop in recent memory. What happened?

Well, the major averages didn't move much during those two weeks, so it wasn't a matter of profit-taking or fears of a short squeeze. Frankly, it's a bit of a mystery and it will be interesting to see the next set of data, scheduled for around July 25 (covering the period through July 15).

Yet, it's noteworthy that the one stock in this table that did see a rise in the short position was eventually hammered -- Supervalu ( SVU) fell nearly 50% on July 11 after the company reported a weak fiscal first quarter and a major restructuring.

This beleaguered supermarket chain has company. Short-sellers have also been targeting chip maker AMD ( AMD), which has the 12th-largest short position on the NYSE. The company recently warned of a quarterly shortfall, and shares are now down nearly 20% since the month began.

Short-sellers also boosted their position in coal maker Patriot Coal ( PCX) a hefty 26% in just the last two weeks of June (to 32 million shares). Days later, the company would declare bankruptcy, reaping a huge payday for short sellers.

Bearish bets also paid off in consumer electronics retailer HHGregg ( HGG). The short position of nine million shares amounted to a whopping 55% of the total float. So after an announcement that quarterly results were dismal, shares slumped a hefty 37% on July 11.

Call it dumb luck, but the four biggest losers thus far in the third quarter were all heavily shorted.

Indeed, whether it's an expected weak quarter or an outright bankruptcy declaration, short sellers are clearly on their game right now. You may want to check out the short position on any of your holdings, and if it's a large one then you need to quickly learn why the short sellers are so bearish. In this market, there's no shame in raising cash, and these heavily-shorted stocks may be good candidates.

So where else are the shorts focused? Here's a quick look at four stocks, and why the shorts see downside ahead.

1. Chesapeake Energy ( CHK)

Even after responding to shareholder requests for a more responsible board of directors, and even after a nice rebound in natural gas prices, short sellers still hold 85 million shares short (which, admittedly is down 5 million from mid-June but still ranks as the 11th-highest short position on the NYSE). Shares, near $19, are actually showing some resilience, even after the Wall Street Journal continues to run a series of stories questioning the company's unstated financial relationships and perhaps overstated gas reserves estimates.

Chesapeake's bulls and bears both make a solid case, and shares are either wildly overvalued or undervalued, according to who you listen to. I can't make heads or tails of it myself. For further insight on this stock, you may want to read Nathan Slaughter's views on Chesapeake in his Scarcity & Real Wealth newsletter if you haven't already.

2. Rite Aid ( RAD)

Shares of this lagging drug store chain have fallen from above $2 in late March to a recent $1.33, which would typically lead short sellers to cash in their winning bet. But they actually boosted the short position by six million shares to 58.8 million at the end of June.

Any time you see a stock trading below $2 with a large short position, you might wonder if this is a candidate for bankruptcy. Will that be the case?

Well, Rite Aid is sitting on more than $6 billion in debt. This means the retailer needs to pay out $130 million in interest expense every quarter. That's a larger sum than operating income, which means that Rite Aid continues to generate quarterly net losses. You can't do that in perpetuity if you have $6 billion in debt.

3. Arch Coal ( ACI)

After scoring a big hit with Patriot Coal, short sellers are targeting this debt-laden rival. As is the case with Rite Aid, Arch Coal has to make huge quarterly interest payments -- roughly $75 million per quarter. Trouble is, the coal miner had just $54 million in operating income in the first quarter -- yielding a net loss -- and second-quarter results are likely to be even worse as coal prices keep on dropping.

4. Facebook ( FB)

After a disappointing debut, shares of this huge initial public offering staged a decent short-term rebound, as I anticipated would happen in mid-June.

Nearly a month ago, I suggested shares would get a lift from a fresh wave of research reports from the company's underwriters in late June. But I also cautioned that actual second-quarter results, set for release later this month, might be fairly tepid. "This suggests booking profits if shares rebound in coming weeks," I wrote back then.

Some short sellers think that's much too passive a strategy and they see a compelling short play emerging. In just the two weeks ended June 29, the short position in Facebook rose a hefty 33% to 60 million shares.

Such a large short position implies that the stock will make a big move when second-quarter results are released, as results will have been as weak as the short-sellers anticipate, or good enough to make the shorts cover and trigger a short squeeze. If you have a strong feeling either way, then puts and calls may be the best way to capture any near-term move.

Risks to Consider: As an upside risk, any heavily shorted stock can post a massive quick gain -- if the short sellers are wrong in their assumptions and are forced to cover their positions.

Action to Take: The market feels winded, having dropped on most trading sessions this month. That may have led to some profit-taking by short-sellers, though the real action will come when second-quarter results are released for each of these stocks. There are times to go against short sellers (for example, a rising market could trigger squeezes). But this is not one of those times. It may be wiser to steer clear of any heavily shorted stocks right now.

David Sterman does not personally hold positions in any securities mentioned in this article. 

StreetAuthority LLC owns shares of CHK in one or more if its "real money" portfolios. 

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

This contributor reads:
Barry Ritholtz
Paul Kedrosky
Brad Delong
Joshua Brown
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