Republicans and Democrats remain at loggerheads over the government shutdown - and, more importantly, the debt ceiling. That's got the supposed "smart money" trading scared. By that I mean, they're increasingly selling stocks short, looking to profit from a nasty market slide.
In fact, an index compiled by ISI Group LLC, which measures hedge fund long versus short bets, fell to 48.4 last week. That's a mere 0.2 above the lowest reading of the year. (A lower number represents a more bearish indicator.)
So with hedge fund managers so bearish, shouldn't we - the supposed "dumb money" - be following their lead? Not just no ... But hell no!
It's Follow the Leader, Not the Laggard
Instead of getting caught up in the headlines - and selling first and asking questions later - we need to get some perspective. And, I'm sorry, but the bearish sentiment for hedge funds hardly qualifies as a breaking development. To the contrary, they've been betting against stocks all year. And the trade has completely backfired.
I mean, the S&P 500 Index is up 19% year-to-date. And a rising market doesn't lead to profits for short sellers. It leads to losses. So instead of cleaning up, short sellers continue to get cleaned out. Case in point: The average hedge fund continues to grossly lag the market, up only 9.2% through the third quarter.
Again, this isn't a new development. Not only have hedge funds been lagging the market all year, but their struggles extend back more than four years. Consider that, since the March 2009 bottom, the S&P 500 is up 111%. Meanwhile, the HFRI Equity Hedge Fund Index is up only 48% over the same period.
When it comes to investing, we want to follow the leaders, not the laggards. So, given the dreadful track record for hedge funds, we should look to do the opposite of what they're doing.
And as it turns out, a compelling, empirical case can be made for doing just that …
Smarter Than the Average Bear
You see, the companies that hedge funds presumably expected to fall the most in price in 2013 actually increased the most, based on data compiled by Goldman Sachs (GS).
Specifically, the 50 most heavily shorted stocks in the Russell 3000 Index are up an average of 38% year-to-date. That's double the return of the S&P 500. Now, part of the outperformance can be explained by the fact that many hedge funds got "squeezed."
As stocks rose in price, they were forced to cover a portion (or all) of their short positions at a loss. Of course, doing so means actually buying shares in the open market. And in the end, the added buying interest pushed prices up even higher.
"There still are people out there who are convinced the whole market and financial system is some house of cards," says Brian Barish, President at Cambiar Investors. That includes hedge funds.
However, the more time that passes without a correction, the more convinced hedge funds become that one is inevitable. In other words, their stubbornness is only increasing.
Eventually, though, they'll have to capitulate, which should lead to the most heavily shorted stocks outperforming the market even more. Such a turn of events could happen as early as this week, once the politicians flesh out a compromise.
With that in mind, here's a list of the 10 most heavily shorted stocks in the S&P 1500 Index at the end of the third quarter.
By no means am I suggesting that all of them represent attractive buys. I'm simply bringing the list to your attention as a starting point for more due diligence.
It stands to reason that any companies on the list with improving fundamentals - and, in turn, unjustified high short interest - will rally the most. A resolution in Washington, D.C. could prove to be the catalyst, as could a better-than-expected earnings report.
If I were you, I'd take a closer look at Bio-Reference Laboratories Inc. (BRLI). Despite increasing short interest, earnings estimates rose over the last 60 days. And shares are certainly not overpriced. They trade in line with the S&P 500 Index on a historical and forward price-to-earnings ratio basis.