Shorts Are Piling Into These Stocks. Should You Be Worried?

The best thing about the stock market is that you can make money in either direction. Historically, stock indexes have tended to trend up over the long term. But when you look at individual stocks, you'll find plenty that lose money over the long haul. According to hedge fund institution Blackstar Funds, even with dividends included, between 1983 and 2006, 64% of stocks underperformed the Russell 3000, a broad-scope market index.

A large influx of short-sellers shouldn't be a condemning factor for any company, but it could be a red flag from traders that something may not be as cut-and-dried as it appears. Let's look at three companies that have seen a rapid increase in the number of shares sold short and see whether traders are blowing smoke or if their worry has some merit.

Company

Short Increase June 28 to July 15

Short Shares as a % of Float

VelocityShares Daily 2X VIX (NASDAQ: TVIX  )

234.6%

N/A*

Johnson & Johnson (NYSE: JNJ  )

26.9%

2.2%

ARMOUR Residential REIT

(NYSE: ARR  )

60.8%

5.7%

Source: The Wall Street Journal. *ETNs do not have a fixed number of shares.

Worrisome worries
If, as an investor, you believe the market is headed lower, there are smart ways of betting in favor of downside action and investing methods you'd want to avoid at all costs. Purchasing the VelocityShares Daily 2X VIX -- essentially an ETN that closely tracks twice the move of the volatility index known as the VIX -- is the absolute wrong way to go about it.

Since early October 2011 when the stock market had its most recent sizable swoon and volatility spiked higher, the VelocityShares double-weighted VIX ETN has lost an astonishing 98.3% of its value. A lack of volatility, time decay, and daily rebalancing, has crushed this ETN built upon worry and volatility and reminded investors in very blunt fashion that double-weighted ETFs and ETNs are rarely, if ever, profitable ventures over the long-term and are better left untouched.

In this case, a huge rise in short interest in VelocityShares Daily 2X VIX is probably well deserved. There will undoubtedly be small rallies in this ETN when the markets head lower and uncertainty picks up. However, over the long run, the factors listed above will naturally take this ETN closer and closer to zero.

Quietly dominating
Many investors have grown quite skeptical of Johnson & Johnson's nearly perfect ascent from $70 to $93 since the year began given its history of steady, but slow growth. At roughly 16 times forward earnings J&J may not be expensive relative to the S&P 500, but historically speaking it and its price-to-cash-flow ratio is higher than in recent years. But short-sellers are ignoring two key components to J&J's business that I wouldn't dare stand in the way of.

First, J&J purchased Synthes last June in a gigantic $19.7 billion deal that was targeted at boosting its orthopedic medical device market share -- but more so to gain a foothold in emerging market regions where Synthes is rapidly growing sales. Even though J&J's consumer products segment is growing at a snail's pace, its orthopedics segment growth could really surprise Wall Street come earnings time.

The other factor that makes J&J a company I wouldn't dare bet against is its top-notch pharmaceutical program. J&J has delivered incredible wins over the past couple of quarters including the approval of Invokana, the first SGLT-2 inhibitor approved in the U.S. to treat Type 2 diabetes, as well as its December 2011 licensing partnership with Pharmacyclics (NASDAQ: PCYC  ) over experimental drug, ibrutinib, which has been designated as a breakthrough therapy by the Food and Drug Administration for the treatment of two rare blood cancers and could generate up to $5 billion in peak sales if approved (it's currently under review by the FDA).

Forget the fact that J&J has increased its dividend in 51 consecutive years, or that its cash flow is about as steady as they come in the health care sector. The real news here is that J&J is retransforming itself into a growth company once again. I believe short-sellers would be foolish to bet against that move.

Don't overthink this
Nearly anything related to the housing market has been a great investment since the March 2009 lows. It's certainly been a bumpy ride, but historically low lending rates combined with very accommodative Federal Reserve monetary policy have come together to create the perfect scenario for housing prices to find a foundation and for homebuilders to regain some pricing power and inventory control. However, it hasn't been the best of times for the mortgage-REIT sector and companies like ARMOUR Residential REIT in the past quarter.

Comments recently made by Federal Reserve chairman Ben Bernanke made it clear that if U.S. economic results continue to pick up, it will begin paring back its quantitative easing program which has been pumping $85 billion into the economy on a monthly basis. This news caused interest rates to rise which has the effect of tightening net margin spreads for mREITs like ARMOUR. ARMOUR makes its profits by levering up and relying on the fact that it invests only in agency-only mortgage-backed securities (i.e., those guaranteed by the U.S. government), which means it cover its behind in case of a loan default.

To some extent, short-sellers have been justified in their pessimism given that net interest margins for agency-only mREITs have been shrinking with regularity for many quarters now. Annaly Capital Management (NYSE: NLY  ) , perhaps the most popular mREIT and a competitor to ARMOUR, has seen its net interest margin sink from a peak of more than 3% to just 0.91% last quarter. The case is the same for ARMOUR, which has witnessed its net interest margin drop to just 1.35% from 2.23% in the year-ago period.

On the other hand, the Fed has been very transparent with its intentions to the leave the Fed Funds target at historically low levels through 2015. That alone should put a cap on the near-term lending rate surge and give these mREITs another two years at minimum to shine. Following a big decline over the past two months, I feel ARMOUR could offer a very intriguing buying opportunity here.

Foolish roundup
This week's theme is all about fleeting trends versus long-term trends. A downward move in the market that boosts the VIX, aka the fear index, could result in very short-term gains for holders of the SharesVelocity Daily 2X ETN, but they're unlikely to see any meaningful gains over the long run. For J&J and ARMOUR, longer-term catalysts do exist that, at their current prices, should make short-sellers think twice before pulling the trigger.

Interested in a company that has short-sellers running in the opposite direction? The Motley Fool's chief investment officer recently selected his No. 1 stock for this year and, for a limited time, he'll share it with your for free! Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access this report and find out the name of this under-the-radar company.


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  • Report this Comment On August 01, 2013, at 2:50 PM, Elbonian wrote:

    I hope the folks shorting Armour (ARR) have deep pockets and are ready for a short squeeze. ARR raised a bunch of new capital back in February, selling 65 million shares, so I don't think ARR is in any position to get squeezed by the up-tick in interest rates. Yes, its portfolio has declined in value, but that is considered to be a "temporary impairment" of the value. ARR intends to keep borrowing short and lending long and receiving the payments from the government agencies. So, it seems to me an investment in ARR can only return the monthly interest payments so long as you ignore the book value and just focus on the income. Buy and hold is the strategy for ARR and its portfolio, and those of us who are willing to do the same with this stock can reap the ongoing rewards.

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