Are Short-Sellers Right This Time?

We all know that 2008 was terrible for investors who had money in stocks. Stocks simply got creamed, most of them. Many investors lost lots of money (well, those who sold did -- many others hung on, knowing that volatility is part of the deal with stocks and that recoveries have always followed drops). This year, 2009, has brought more of the same, until the recent rally. Did anyone make any money during the bear market?

Well, yes. Some people were just invested in some of the right stocks -- because some stocks did actually gain in value in 2008. Wal-Mart (NYSE:WMT) gained 20% that year, for example, while Family Dollar (NYSE:FDO) gained 38%. Other people who made money were short-sellers -- people who bet against certain stocks or the whole market.

When you short a stock, you borrow shares of a company from your brokerage and then sell them, planning to repurchase and replace them later, when they fall in price. It's essentially buying low and selling high, with the order reversed.

Let's get short
Looking at short interest on particular stocks gives you some interesting information. It makes sense, after all, that if a stock is heavily shorted, a lot of investors don't think well of the company's prospects. Of course, that doesn't necessarily mean the stock price will actually drop, but some research suggests that portfolios of heavily shorted stocks have tended to underperform the market.

However, over significant periods of time, that relationship has sometimes reversed itself. One group of researchers, for instance, looked at the period from 1995 to 2002 and concluded that heavily shorted Nasdaq stocks didn't perform significantly worse than the market as a whole. So trying to draw conclusions with too much confidence may prove misleading.

Moreover, betting against stocks with high short interest can be dangerous. In a short squeeze, some event makes the stock start to go up, and short-sellers who start losing money panic and buy shares on the market to replace the ones they borrowed and close out their short positions. That buying can send the stock price still higher, leading to more short investors covering in a vicious cycle.

Who's short now?
Here are a few companies that recently sported fairly high short ratios -- the number of shares shorted divided by the stock's average daily volume:

Data: Yahoo! Finance.

Of course, such screens are limited. You'd need to know much more about a company before you drew many conclusions. Just from the table above, you can see that companies can vary widely on various measures while being shorted to similar degrees. You might also look into short interest over time, to see how sentiment about your holdings changes.

Dig deeper
So if you're looking at a company, paying attention to short-selling activity makes sense. At the very least, it can alert you to warning signs about a potential investment. And sometimes, it may save you from making a terrible investing decision.

Learn more:

• Is This the Market Bottom?
• Now It's Time for Short-Sellers to Panic
• Beating Back the Short Attack