It's time to harness the power of hate.
Believe it or not, hate can be a profitable emotion for your portfolio, one that statistically hands out massive outperformance to investors who are paying attention. Hate is a useful market indicator because, more often than not, it's wrong.
When I talk about "hate" here, I'm talking about short interest. The more short interest, the more investors hate a given stock, enough to actively bet on a decline in its share price. And when shorting becomes a crowded trade, it can create a market phenomenon called a short squeeze.
The stats show that being contrarian pays off in big, hated stocks. 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.
In other words, the largest massively shorted stocks are more likely to squeeze higher than to drop...
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 four 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.
Sirius XM Holdings Inc.
Leading things off today is $22 billion satellite radio company Sirius XM Holdings Inc. (SIRI - Get Report) . Sirius XM is the largest radio company in the world by revenues, and it's a stock that's been frustrating short-sellers in a big way lately. In the last 12 months, Sirius XM has rallied almost 40% higher, chopping away at shorts' prospects of ever seeing a return.
And yet, short-sellers continue to pile into Sirius XM this winter. As I write, more than 15% of Sirius' float is being held short. That implies more than two weeks of nonstop buying would be needed for shorts to exit this trade at current volume levels.
Sirius XM operates a satellite radio network of commercial-free music, sports, news, comedy and talk content, hundreds of channels in all. The firm counts more than 30.6 million subscribers to its service. Sirius XM also provides telematics data, and traffic and weather data for the marine and aviation markets, as well as a stake in SiriusXM Canada. The firm's sales funnel is powerful. The company has deals with nearly every major automaker to bundle satellite radios and trial subscriptions with new vehicle purchases, providing a large source of recurring leads.
The firm's scale and pay model, in turn, gives it some major advantages over terrestrial networks. Sirius' ability to spread programming costs across millions of listeners means it can afford major celebrities, like Howard Stern, which increases the economic moat it enjoys over alternatives. A big chunk of SIRI's short interest is coming as a result of speculation that the firm could work out a deal to buy internet radio stock Pandora Media (P) . That doesn't change the likelihood of a short squeeze here. Meanwhile, buyers are clearly in control of Sirius XM's price action in 2017.
Paychex Inc. (PAYX - Get Report) is another heavily shorted, large-cap that's been on a tear lately. This payroll services company is up nearly 25% on a total returns basis in the trailing 12 months, leaving the rest of the broad market in its dust. That hasn't scared short sellers off completely yet. Currently, Paychex's short interest ratio sits at 10.19, implying more than two weeks of nonstop buying would be needed at current volume levels for short-sellers to exit their bets.
And yesterday's comments from Janet Yellen that the Federal Reserve could be ready to hike interest rates again as soon as March could help squeeze shares even further in the near-term. More on that in a moment.
Paychex provides payroll services for more than 590,000 customers, primarily small- and medium-size businesses. The firm helps those smaller firms navigate the maze of tax and compliance issues involved in paying employees and earning profits in the process. The firm also offers other outsourced HR functions, including 401(k) administration and worker's comp insurance.
Recent strength in payroll numbers has been a major positive for Paychex—more employment means more services for payroll outsourcers. But don't mistake this stock for an employment play: it's really an interest rate play.
Paychex has historically 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 parlay into a big revenue enhancement at Paychex. Keep an eye out for more rate murmurs as a potential upside catalyst ahead of third-quarter earnings next month.
WEC Energy Group
In theory, short sellers should be celebrating the rate hike when it comes to high-yield investments like utility stocks. After all, higher rates translate into lower share prices for the rate-sensitive investments that income investors have been flocking to as a source of yield; as low-risk assets pay higher yields themselves, utilities become comparatively less attractive.
WEC Energy serves 1.6 million electric customers and 2.8 million gas customers in Wisconsin, Illinois, Michigan and Minnesota. The firm is a model of what other utilities have been working toward, with 99% of earnings generated by regulated operations. The firm boasts 70,000 miles of electric distribution, 44,000 miles of gas lines and a $17 billion rate base as of the end of 2016.
The favorable regulatory environment in the states where WEC operates provides an important tailwind: in a higher rate environment, the firm should be able to justify rate improvements that enable dividend payouts to move in line with the hikes. Likewise, the price action continues to look attractive in the long term. Technically speaking, WEC has been setting up for a bullish reversal, a push through $60 could be the catalyst for a more prolonged move higher.
Meanwhile, WEC's short interest ratio sits at 10.1.
Digital Realty Trust
Like the WEC trade we just looked at, REITs are primarily used by investors seeking yield exposure, and that plays a big role in short-sellers' piling in against this stock. As I write, DLR's short interest ratio sits at 14.48, with more than 11% of this stock's float being shorted. There's just one problem with that approach: REITs have historically been able to rise alongside rate hikes, which means that DLR isn't the great short trade so many short-sellers think it is. Instead, it's got plenty of squeeze potential.
Digital Realty owns and manages technology-related properties, such as datacenters, internet gateways and manufacturing facilities. The firm owns more than 140 properties comprising more than 26 million square feet of leasable space. The datacenter niche gives Digital Realty a valuable corner of the real estate market, helping the firm profit as demand for data storage and server rack space continues to move up and to the right.
The tech focus has helped to fuel a nearly 38% total return over the course of the last 12 months in DLR, and it's left short-sellers feeling less than confident in their bets. Look for fourth -quarter earnings numbers this week as a potential short squeeze catalyst in Digital Realty Trust.