Why Pessimists Are Piling Into These 3 Dow Stocks

For many investors, Friday marked a joyous occasion -- even if it was more psychological than anything else. Thursday marked the Dow Jones Industrial Average's (^DJI -0.11%) first close above the 17,000 mark, further putting the Great Recession in the rearview mirror.

The big news this week that helped set the stage for another record close was the monthly release of jobs data from the U.S. Department of Labor. According to its report early Thursday morning, 288,000 nonfarm payroll employments were created in June, far ahead of the 210,000 to 230,000 jobs that economists had been forecasting. It also was enough to push the U.S. unemployment rate down 0.2% to just 6.1%. By comparison, unemployment stood at 10% during the recession.

This jobs report comes on the heels of additional data that has been working in the Dow's favor, including manufacturing and factory orders data that's remained strong, higher consumer confidence figures that could imply robust spending in the future, and historically low lending rates that are encouraging consumers to buy homes and other big-ticket items.

Source: Kimco Realty, Flickr.

However, feel free to ask any skeptic and you'll get a far different story.

Although the unemployment rate has fallen, it's come at the expense of a large drop in labor participation. Some of this relates to a demographic shift in baby boomers retiring and dropping out of the workforce, while other components could include people dropping out of the workforce to go back to college. Yet this drop also may include a significant number of workers who've simply given up on trying to find work. The mean duration of unemployment is now twice as long as it was roughly five years ago, so it's not hard to imagine workers being discouraged if they're unemployed.

Also, despite the stock market's rally to new heights, it's not as if businesses have given investors much to cheer about. Quite a few companies have turned to cost-cutting and operational improvements, as well as share buybacks, to boost their bottom line. While this does make a company's stock appear cheaper, it merely masks a lack of organic growth.

With these points in mind, I suggest we do what we do every month, which is take a closer look at the Dow's three most hated companies -- in essence, the three stocks with the highest level of short interest -- to better understand what characteristics, if any, are attracting short-sellers so we can avoid buying similar stocks in the future.

Here are the Dow's three most hated stocks:

Source: S&P Capital IQ.

AT&T
Why are investors shorting AT&T?

• The way I view it, there are two main reasons pessimists have been piling into AT&T the past couple of months. First, there's skepticism surrounding whether the deal to buy DirecTV (DTV.DL) for $48.5 billion will go through. Although the two business models would complement each other and the deal shouldn't affect pricing or competitive choice for consumers, the FCC may view the deal differently. If that were to happen, AT&T could wind up playing catch-up to its peers that have been consolidating. In addition, AT&T is a defensive stock. It's a slow-growth, high-yield dividend play that's pretty much not going to be able to keep up with a fast-growing bull market. This means more risk-taking investors have been willing to cycle out of AT&T for higher growth names, potentially pressuring AT&T's share price.

Source: AT&T.

Is this short interest warranted?

• Arguably, a mobile phone or landline is a basic-needs product, and I rarely suggest betting against basic-needs goods. AT&T has incredible pricing power and a reliable high-speed wireless network, and it also boasts the most loyal customer base among mobile subscribers. I can attest to this fact, as I've had AT&T as my mobile carrier for 16 years and counting. Even if AT&T runs into issues with its DirecTV assimilation, it still has the tools and innovative capacity in place to deliver 2%-4% top-line growth and steady cash flow returns for years to come. As a low-beta, high-dividend play, I certainly wouldn't suggest placing your bets against Ma Bell.

Intel
Why are investors shorting Intel?

• The bet against chipmaker Intel continues to be based on the notion that since PC sales are declining in favor of mobile devices, it's going to have to spend billions of dollars on research and development to catch up with its peers. Short-sellers aren't too concerned about whether Intel's new designs help it earn a spot in smartphones or tablets. Instead, they're expecting higher costs to weigh on its profitability and stymie its dividend growth, ultimately pushing its share price lower in the near term.

Source: Intel Free Press, Flickr.

Is this short interest warranted?

• I believe the answer to that is a resounding "no," as short-sellers in Intel were absolutely burned in June following its earnings guidance update. For the upcoming quarter, Intel raised its revenue guidance to a range of $13.4 billion to $14 billion from a prior expectation of $12.5 billion to $13.5 billion. It also boosted the midpoint of its gross margin forecast by 1% to 64%. The reason behind its updated guidance was strength in the enterprise PC market, which Wall Street had long cast off as dead. While it's undeniable that we're seeing a shift toward mobile devices, Intel's legacy PC business is going to continue to reward investors with hefty margins and cash flow for years to come. It's also seeing steady inroads in tablets and in data center hardware, so it's not as if Intel is truly struggling in any meaningful way. Long story short, no, I don't believe its current short interest is warranted.

Caterpillar
Why are investors shorting Caterpillar?

• Pessimists have been a mainstay in Caterpillar for a few years now, as commodity prices have decreased and orders for heavy-duty equipment have fallen. Short-sellers are simply counting on orders for mining equipment to remain weak until commodity prices improve and China's GDP begins to tick higher once again. Even though Caterpillar's latest earnings report led to better-than-expected results, three separate earnings warnings from last year are still etched into the minds of pessimists.

Source: Caterpillar.

Is this short interest warranted?

• Out of the three Dow components that short-sellers have piled into, Caterpillar makes the most sense to bet against. Its recent earnings report has indicated that the worst may be over. In the first quarter, for instance, it topped Wall Street's EPS expectations and raised its full-year outlook. But my concern is that Caterpillar still doesn't have great earnings visibility. Whereas overseas markets used to be its saving grace, even they're no guarantee of growth at the moment. If you're investing in Caterpillar over the long haul then you probably don't have too much to worry about here, but over the next one to three years I could certainly see instances where short-sellers could come out on top.