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It is little surprise that the stock market rallies will more likely falter than hold ground. After holding steady at 1,175 on Wednesday, September 28, the S&P 500 (NYSEARCA:SPY) dropped 2.07% to close at 1151.06. Markets priced in an expectation of QE3, quantitative easing. This is an event that will not occur, unless global markets falter in an exceptionally bad way.

Investors may use short interest as a way to look at companies likely to offer exceptional gains as the growing unease unfolds. Heavily shorted stocks signal either troubles with the company, or excessive valuation. Since valuation is not a sufficient reason for stocks to keep falling in the long term, long-only investors need to stick to companies that will survive negative outlook.

Ticker

Short Interest Name

Short Interest Float %

Equity Float (mln shrs)

Equity Float (In mln shrs)

(ATPG)

ATP OIL & GAS

43.14

19.16

44.4

(NASDAQ:OCZ)

OCZ TECHNOLOGY

39.21

17.25

43.99

(CSTR)

COINSTAR INC

35.43

10.74

30.32

(NASDAQ:FSLR)

FIRST SOLAR INC

31.68

18.85

59.51

(NYSE:CIEN)

CIENA CORP

28.08

26.35

93.83

(NASDAQ:GRMN)

GARMIN LTD

20.88

22.42

107.38

(NASDAQ:NFLX)

NETFLIX INC

18.74

9.56

51.04

(NASDAQ:CREE)

CREE INC

18.28

20.58

112.57

(NASDAQ:TIVO)

TIVO INC

15.12

17.68

116.94

(PANL)

UNIVERSAL DISPLA

14.65

5.76

39.31

(NASDAQ:LULU)

LULULEMON ATH

13.38

13.13

98.11

(NASDAQ:OTEX)

OPEN TEXT CORP

12.97

7.26

56.01

(NASDAQ:THRX)

THERAVANCE

11.16

7.4

66.34

(NYSE:LVLT)

LEVEL 3 COMM INC

11.1

190.63

1717.61

(NASDAQ:DRIV)

DIGITAL RIVER

10.93

4.18

38.27

(NASDAQ:BCSI)

BLUE COAT SYSTEM

10.25

4.23

41.24

Selected Short Interest as of Sep. 15, 2011 (source: Bloomberg)

Five stocks stand out from the sea of heavily shorted stocks.

1) ATP Oil and Gas (ATPG)

Discussed frequently here on seeking alpha, ATP is highly leveraged, has an unhealthy balance sheet, and is still thought to be worth anywhere from $30 - $90. Trading at $9.15, ATP dropped 8.59% recently and is far from the net asset value management touted as being $90.00 last year. The short interest is 43.14%. ATP is a leveraged energy play: if oil prices rise, ATP shares will rise even faster. The bottom line is that the risk levels are too high to depend on the call for higher energy prices for share appreciation. Avoid ATP.

2) Coinstar Inc. (CSTR)

Coinstar is thought to benefit from the well-known stumble of Netflix Inc. (NFLX). Investors disagree. The short interest for Coinstar is 35.43%. It would seem logical that the company is worth more. This is incorrect. Depending on the missteps of a competitor is not a sufficient reason to buy Coinstar. Avoid Coinstar.

3) Ciena Corp (CIEN)

Ciena has a short float of 28.08%. Trading at near its 52-week low at $11.37, Ciena is a network equipment play, and would look like a good investment. If history is any indication, network equipment makers will face significantly weak earnings if the economic outlook is correct.

The markets are signaling weakness ahead. In the semi-conductor space, spot prices for memory continue to be in a downtrend. The price of copper dropped over the last few weeks. This suggests that network gear makers will face challenges.

The bottom line is that Ciena warrants being added to the watch list. Should evidence emerge that general demand is stable, Ciena would be a buy.

4) Theravance Inc. (THRX)

Theravance is on the bottom of the short interest list, with a short float of 11.16%. Legendary investor Seth Klarman holds a position in Theravance. Klarman also accumulated the shares when it was in the teens. Theravance develops products for the central nervous system and respiratory diseases. GlaxoSmithKline (NYSE:GSK) has a large share ownership in the company. If the company requires more cash, GSK is likely to help Theravance. For these reasons, Theravance is a buy.

5) Level 3 Communications (LVLT)

After being cleared by the office of Fair Trade, Level 3 acquired Global Crossing (NASDAQ:GLBC). Level 3 continued to drift lower at $1.56 after peaking at nearly $2.60 in July. With the acquisition premium in Level 3 gone, Level 3 still made the short interest list, with a short float of 11.1%. Level 3 has a bright future. It is now offering direct 1 and 10 Gigabit-per-second connections to Amazon Web Services (NASDAQ:AMZN). Given expected demand for Amazon’s cloud data with the release of the kindle tablet, Level 3 will be an indirect beneficiary in Amazon.com’s success.

Source: 5 Stock Picks In A Sea Of Heavily Shorted Stocks