BALTIMORE (Stockpickr) -- Wall Street's hate meter is going off the charts this fall.
As I write, total U.S. short interest, a measure of investors' bets against stocks, is the highest it's been since September 2008. Put another way, investors haven't bet this big on a stock market drop since the depths of the financial crisis. So yes, there's a lot of hate piling up in the stock market right now, and that's a powerful emotion for investors.
It's powerful because, more often than not, it's wrong.
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.
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.
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.
Up first is $30 billion energy utility company Exelon (EXC) . Exelon has consistently made the list of most heavily-shorted large cap stocks in 2014, and it's been a particularly painful one for short sellers. Since the calendar flipped to January, EXC has rallied more than 30%. As I write, EXC's short interest ratio weighs in at 11.15, which means it would take more than two weeks of buying pressure for shorts to cover their bets at current volume levels.
Exelon owns a combination of regulated utilities and non-regulated energy assets. The firm's regulated utilities provide power and gas to approximately 6.6 million customers spread across the Central and Eastern U.S., and it's also the largest power retailer in the country, with some 150 terawatt hours of load capacity. On the generation front, EXC is the largest nuclear plant owner in the U.S., positioning that gives the firm access to incredibly cheap power at the same time that fossil fuel power plants are dealing with prolonged rising input costs.
Exelon has been a major growth-by-acquisition name in recent years, first with the $7 billion purchase of Constellation Energy in 2012, and now with the pending buyout of Pepco (POM). It's safe to assume that much of EXC's short interest comes from merger arbitrage bets on the Pepco acquisition, but it doesn't really matter why short sellers are taking positions against Exelon -- only that they are.
Look for pending merger approvals from FERC, the Public Service Commission and state utility agencies in the next few months as potential upside catalysts.
$15 billion regional bank M&T Bank (MTB) is another perennial highly shorted stock that looks primed for a squeeze this fall. The firm's short interest ratio of 14.8 isn't just on the high-end of its historic range -- it also indicates that it would take nearly three full weeks of buying pressure just for short sellers to exit this stock.
M&T's "regional" descriptor doesn't really do it justice; the firm is one of the 20 largest banks in the country, with a footprint that reaches from Virginia to New York and everywhere in between. All told, the firm boasts more than 725 branches and $85 billion in assets. M&T was well-run through the financial crisis, sticking to its core retail and commercial banking businesses, rather than the exotic instruments that ensnared the bigger banks. As a result, the firm's loan book was in better shape than its bigger peers, and it was well positioned to grow by acquiring smaller banks.
One such acquisition has been a major driver of the short-interest in MTB: the ongoing delayed plan to buy Hudson City Bancorp (HCBK) once M&T resolves some regulatory compliance issues that could stand in the way of a merger. Ultimately, those speed bumps are temporary, and once resolved, they should clear the way for a combined bank to perform at a higher level. And despite higher expenses related to those regulatory changes, MTB continues to be a very profitable bank.
M&T is a name that could pay off well for patient contrarians this fall.
The short bets haven't been paying off in shares of Realty Income (O) . So far in 2014, this $10 billion real estate investment trust has seen its share price rally by 20%. That's not very surprising -- dividends are like kryptonite for short sellers, and that makes Realty Income's monthly dividend check (a 4.9% yield at current price levels) even more brutal.
Realty Income is the prototypical retail REIT. The firm's portfolio of some 4,200 properties are mostly well-located single tenant retail locations, and they're leased on a long-term triple-net basis. That means that it's the tenants, not Realty Income, who are responsible for insurance, maintenance, and taxes. That structure, and the fact that REITs are legally required to pass the vast majority of their income directly to investors, means that Realty Income is more of a pure play on income than a way to get exposure to real estate. One side effect of that is that the likelihood of even more prolonged low interest rates translates into big gains at Realty Income.
Historically, Realty Income has been able to deliver very attractive returns for investors. And while the firm's large size is making it more difficult to "move the needle", the combination of a high dividend yield and price momentum make that point moot this fall. Meanwhile, Realty Income's short interest ratio stands at 11.56.
Quest Diagnostics (DGX) is seeing considerable upside in the fourth quarter, especially as investors ponder the implications of more infectious disease cases (like Ebola) in the U.S. Quest provides clinical testing at a network of 2,000 locations across the country. If you've taken a blood test or a drug screening in the last few years, there's a good chance it was at one of Quest's facilities.
While Quest doesn't perform Ebola testing (only public health laboratories like the CDC currently do in the U.S.), the firm does have an infectious disease testing unit that tests patients for other communicable diseases. Other diagnostic businesses that go beyond routine work includes clinical trials and esoteric testing. Quest has some big secular tailwinds pushing at its back right now, as an aging U.S. population and increased health insurance coverage adds to the number of potential customers demanding Quest's services. Likewise, the barriers to entry are large in the diagnostic testing business, and that means that Quest is able to collect some big margins for its efforts.
Newer products, such as genetic testing, are only helping to boost those margins even more. Right now, investors are making big bets against Quest; the firm's short interest ratio stands at 11.46. At that level, it would take more than two weeks of buying pressure for sellers to exit their bets.
Last up on our list of hated short-squeeze candidates is security company ADT (ADT) .
ADT owns an extremely attractive business. The only problem is that the business has been trading for an extremely unattractive price for much of 2014. With a correction in place and new growth opportunities ahead, this stock's positioning looks a lot better than it did at the start of the year.
ADT provides burglary, fire and carbon monoxide monitoring as well as home automation services for more than 6.4 million residential and small business customers in the U.S. and Canada. The firm is the league leader in the security business, with 25% of the total market. More recently, the firm has expanded into midsize commercial security, an addressable market that the firm believes could be worth $10 billion.
Because ADT's customers sign lucrative, relatively long-term contracts to add ADT's services, multi-year retention rates are extremely high. And because customers go to the trouble (and expense) of installing ADT hardware on their premises, switching costs are even higher. We'll get our next glimpse of ADT's growth in the firm's fourth-quarter earnings call on Nov. 12.
Meanwhile, ADT's short interest ratio stands at a whopping 15.97.
To see these short squeezes in action, check out this week’s Short Squeezes portfolio on Stockpickr.
-- Written by Jonas Elmerraji in Baltimore.