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There seems to be a new trend taking place in the markets. It's both the avoidance of crowded trades no matter what the valuation, and the seeking of highly shorted names, with the high short interest being a proxy for unloved stocks. Put another way, there seems to be a large contingent of investors, including hedge funds, which are actively seeking to get out of loved stocks and seeking to enter unloved stocks. Some of these investors might even be motivated by the chance to produce short squeezes in the unloved stocks.

This was plain to see during Q4 2012. Many hedge funds (as well as regular funds) left the Apple (NASDAQ:AAPL) boat, while many others entered Amazon.com (NASDAQ:AMZN) at least in part because it was so unloved (if we take Capital Group's words after Amazon.com reported earnings for Q4 2012, in a Bloomberg video story).

There might be a method to the madness

While a crowded trade can always turn into something ugly, it seems like a new development to have large investors purposely leaving trades in droves because of their crowded status. This might be happening due to the knowledge that the market is significantly levered, so it's as easy to produce short squeezes as to produce long squeezes.

It's even weirder to have someone like Icahn seemingly targeting stocks just on account of their having a large short open interest.

Icahn targeting shorts?

While it might be a coincidence, it's strange to see Icahn increasing positions (One, Two) in Herbalife (NYSE:HLF), Navistar (NYSE:NAV), Netflix (NASDAQ:NFLX) and Chesapeake Energy Corporation (NYSE:CHK) in the same quarter. What is the one thing connecting all these names? They all share a large short interest. Herbalife is at 34.8% of the float shorted, Navistar is at 33.7%, Netflix is at 17.9% and Chesapeake is at 13.5% of the float shorted. In a market that isn't even particularly shorted, this stands out like a sore thumb; it seems Icahn is actually conscientiously choosing these situations and perhaps even creating short squeezes himself.

It leads to unreal situations

For instance, the migration from Apple to Amazon shares produced truly amazing effects, I will cite just two:

  • First, if one had bought Amazon.com instead of Apple on the day Apple announced the most successful product in history, the iPhone, one would have made more money, even though in the following years, Apple turned into the most profitable company on earth while Amazon.com lost the entirety of its earnings;
  • Second, by leaving Apple in droves while driving Amazon.com higher, the effects on valuation both of Apple and Amazon were so great, that Amazon.com is now worth almost half of Apple's enterprise value (which discounts the cash and investments Apple holds). This is truly extraordinary, to have a company with no earnings worth almost half as much as the most profitable company out there.

What makes for this weird market?

Why are large and informed investors seemingly running around like headless chickens? Why is the need to buy something and the certainty of short squeezing any shorts so great? The one culprit is the Federal Reserve. The Federal Reserve is doing everything it can to herd people into stocks, both by keeping interest rates at 0% for an extended period, and by not letting up in its quantitative easing campaign, now at $85 billion per month.

Rationality is slowly going out the window as investors speculate frantically to try and stay ahead of a deeply artificial game at this point. Those who are trying to keep their rationality, like Einhorn on Apple or Ackman on Herbalife, are slowly being pounded into submission - into accepting the new normal and also join the frenzy.

At the same time, I re-iterate that we're seeing a level of leverage which is usually synonymous with significant market disruption. Again, the only thing standing between us and a cleansing of this excess speculation is the Federal Reserve.

Conclusion

The Federal Reserve continues to distort the equity market, leading to ever more irrational moves. At this point, it even seems that some large investors are actively seeking situations where they can produce short squeezes. At the same time, leverage has gone ballistic, some of it probably being used in the squeezes.

The Federal Reserve ought to remove itself from its newfound role as a chooser of winners.

Source: The New Market Dynamic: Sell Love, Buy Hatred