August Is the Cruelest Month for Shorts

 |  Includes: DIA, QQQ, SPY
by: Dan Knight

By Dan Knight

The month of August is quickly becoming a month of misery for hedge funds and short sellers in particular. Like last year, when the credit crisis seemed to initially explode and cause many large hedge funds, particularly quant-based ones that employ long/short strategies, to suffer massive losses, this year's August is doing the same.

The 10% most heavily shorted stocks are outperforming the 10% least shorted stocks by over 15% month to date. And this isn't a Financials versus Energy sector rotation, it is across the board, across all sectors. Consequently, many hedge funds pursuing a relative value strategy of owning stocks that look cheap to earnings, with good relative strength and a pattern of improving earnings expectations, and being short stocks with more or less the opposite characteristics, are seeing significant losses this month. Most of these heavily shorted stocks are less liquid than average, so the influence of the short sellers covering their positions is causing significant upward pressure on prices, and as the prices keep going up, and the short sellers losses magnify, stop loss thresholds kick in like a domino effect, bringing even more pressure for the shorts to cover.

For investors who don't employ short selling, the key is to not be fooled by this near term exceptional performance of these heavily shorted stocks - they were shorted for a good reason and are likely to sink soon after the artificial buying pressure subsides. They are typically over-valued relative to their fundamentals, or have much higher prices than their growth and earnings prospects would prudently suggest, so don't take their recent strength as a signal to buy. If anything, if you own any of these stocks, look to sell into the strength before they roll back over and retrace their recent gains.

When the short-covering rally fades is anyone's guess, but if last August is a sign, it ended after about 2 weeks, so consider acting soon to take advantage of the short seller's misery.