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Recently, there has been much ado about various short sellers taking significant losses in stocks such as Netflix (NASDAQ:NFLX) and The St. Joe Company (NYSE:JOE). Short selling plays an important role in all markets, not only by allowing market participants to hedge long positions, but also by keeping the bulls honest and helping to provide the proverbial “wall of worry” for the market to climb. Short sellers often get a bad reputation because, by definition, the majority of market participants are long and short sellers are thought of as the enemy.

I can’t count the number of times in recent months that I have seen traders on StockTwits tweet how “the shorts are getting murdered” or “you’d have to have a death wish to short XYZ stock”. During a raging bull market the short sellers are the enemy, they are the Darth Vaders of the market, and as the market surges higher short sellers become more of an endangered species. In fact, during a strong market uptrend the longs should be thanking short sellers for providing them with extra profits. As famed short seller Doug Kass of Seabreeze Partners has stated on numerous occasions, “valuation alone is not reason enough for shorting a stock”. Mr. Kass also does not short stocks with short interest ratios above 10% due to the much higher likelihood of a so called short squeeze. One doesn’t have to look far to find some examples of brutal short squeezes caused by overconfident short sellers who short stocks based on ‘valuation’.

The most recent example of a vicious short squeeze occurred in the German traded shares of Volkswagen (VW) during October 2008. Legendary hedge funds such as Greenlight Capital and SAC Capital were caught short of VW shares as the shares surged to unsustainable levels following Porsche’s announcement that it had increased its stake in VW shares through the options market (avoiding the usual disclosures required when a large shareholder increases their position). The ensuing short squeeze cost short sellers of VW shares dearly, and even briefly gave VW the largest market capitalization of any company in the world. This absurd situation clearly demonstrates the old adage, “markets can remain irrational longer than you can remain solvent”.

The current situations in JOE and NFLX remind me of some of the great short squeezes in market history. JOE in particular which has a large short interest of 29.48% (as of January 14, 2011) appears ripe to be the short seller’s Waterloo. Strangely enough, David Einhorn’s fund Greenlight Capital, which was burned in the VW short squeeze, is also on the short side of this trade. Einhorn is a legend and I have a tremendous amount of admiration and respect for him, however, I must wonder if he has once again picked a fight he can’t win on the short side.

Einhorn’s opponent Bruce Berkowitz’s Fairholme Fund has very deep pockets (approximately $22 billion in assets under management) and has had a hot hand over the last two years. JOE’s board (Berkowitz is a board member) recently voted to allow Fairholme to increase its stake as they pleased. Berkowitz has publicly stated on multiple occasions that Fairholme would like to buy all of JOE:

“I have said in the past that I would like to buy the whole company (JOE) if I could buy the company ... We bought our St. Joe position for pretty much swampland prices. We’ve been down there, we like what we see.” - Berkowitz

The stage is set for a potential massive short squeeze if Fairholm and other JOE longs decide to snap up all the shares and place them in non-marginable brokerage accounts. This would make shares of JOE unshortable and force current short sellers to cover all of their short positions. Einhorn is very smart; however, being smart and believing that something should be worth less than the market perceives it to be worth doesn’t make one a profitable short seller, just ask Whitney Tilson about NFLX.

Source: Bulls Should Embrace Short Sellers With Open Arms