By David Sterman
After a couple of weeks of steady losses, the stock market is now in all-out frenzy mode. Massive drops or eye-popping gains are the norm these days, creating havoc for anyone trying to establish a foothold with long or short-oriented investments. In fact, short sellers are the most exposed in this current era of high volatility, even with their potential of reaping huge gains, as they have recently.
Short sellers need to watch out for sudden rallies. If they are targeting a heavily-shorted stock, then a short squeeze could push up the stock up faster than the broader market, creating potentially huge losses for shorts -- yet equally large gains for investors who went long.
With this in mind, I've been looking at the just-released short-interest data, which tallies the short-interest levels in stocks as of July 28. The size of these short positions may have changed since then, but almost all of the most heavily-shorted stocks are likely to remain near or atop the leader board when we get the next round of data that tracks short levels through Aug. 15.
Make no mistake, some heavily-shorted stocks are clearly in deep trouble, and any sort of market rally is unlikely to rescue them. Nokia (NOK), Sprint Nextel (S), Eastman Kodak (EK), AMR (AMR) and Rite-Aid (RAD) are all in the sights of short-sellers and appear to have very bleak futures. But not all heavily-shorted stocks look set for a sharp pullback. Here are four shorted stocks that could post a powerful rally when the market's downturn comes to an end.
1. Ford Motor (F)
Shares held short: 148 million
This was the most heavily-shorted stock on the market, according to recent data. Since July 28, shares have fallen from $12.32 to near $11. In effect, anyone who invested in this turnaround story back in January 2010 initially saw her investment nearly double during the following year, but now has seen all of those gains wiped out.
The difference between then and now is quite stark. In January 2010, Ford had just wrapped up a year with sales falling 19% to $116 billion and earnings per share of just $0.86. This year, Ford is on track for $125 billion to $130 billion in sales and, much more importantly, earnings per share of about $2. The stock traded for 11 times trailing earnings in January 2010 but now trades for just five times projected 2011 profits. And this is in a lousy economy. Imagine what Ford could do when the current economic pall lifts. It's no fun owning a stock like this in a market rout, but the long-term outlook is just too appealing to ignore. (Note: I like to swing from a look at valuations relative to trailing earnings before June 30, to a look at projected earnings once the year reaches the half-way point -- hence the apples-to-oranges comparison.)
2. AMD (AMD)
Shares held short: 102 million
In a similar vein, shares of this chip maker have been pummeled in the market dive. When I profiled AMD in late July, I noted the company's new line of microprocessors was starting to gain traction, setting up a possibly painful short-covering by short-sellers. Since then, the stock market has done the handiwork of short-sellers, pushing the stock down roughly 20%. But short-sellers could still face real pain. In the next month or two, semiconductor analysts are likely to provide an updated view on the potential traction AMD is starting to make with PC and server makers. Expectations remain very low, judging by the stock price, which is the perfect backdrop for a short squeeze.
3. EMC (EMC)
Shares held short: 78 million
It's curious to see this tech titan still near the top of the list of heavily shorted stocks. In May, when shares traded at $28, I thought they were vulnerable to growth expectations that might never materialize. As I noted then, the stock was trading at more than 20 times trailing earnings, which was "simply too rich for such a sober current environment for tech spending." However, the subsequent selloff down to $21 no longer brings this same overvaluation concern. Shares now trade for just 14 times projected 2011 profits. It's worth noting investments in storage and "cloud computing" remain a priority for information technology planners, even as other areas of IT will be throttled back. EMC has been -- and will remain -- at the forefront of this trend.
4. SuperValu (SVU)
Shares held short: 43 million
This one is truly a head-scratcher. Short-sellers have been targeting this grocer for nearly two years because they expect Supervalu's high debt load to cause its demise. But for much of this time, Supervalu has been delivering better-than-expected quarterly cash flow. In addition, as I noted on Aug. 2, Supervalu is on track to generate roughly $2 billion in free cash flow between now and 2015, much of which should be applied to the reduction of long-term debt.
With less debt on its books, what's left for short-sellers to focus on? Well, the grocer is clearly underperforming in terms of sales, losing business on the low end to Wal-Mart (WMT) and on the high end to Whole Foods (WFM). Still, even with a dismal sales picture, the company is able to throw off ample cash flow. Supervalu's shares went from $8 to $11 this spring when investors realized the robust nature of the stock's cash flow. But the recent market rout has forced shares all the way back down to around $7. In a stable market, this stock still has the potential to make trouble for short-sellers.
Keep an eye on the market's most heavily-shorted names. Any mini-rallies in this environment could take their shares sharply higher. If you're thinking about short-selling these stocks, think again. But if you're looking for deep value opportunities, these are great holdings because these four names have great potential for a rebound.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.