Short Sellers Know More Than You Do

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"The spring
in

her step
has

turned to
fall."

-- "Beautiful Woman," by A.R. Ammons

A recent research report in The Journal of Finance picks apart five years of trading data from proprietary records of the New York Stock Exchange (NYSE: NYX). With information on which trades came from manual or automatic actions at large institutions, and which ones had individual investors behind the wheel, the research team focused on short-selling activity -- and found that the big boys tend to know what they're doing.

What's the big deal?
The data under the microscope goes from 2000 to 2004, a period that includes the well-documented end of the tech bubble. On the other hand, the NYSE is a lot less tech-infused than the Nasdaq Stock Market (Nasdaq: NDAQ), ameliorating that obvious bias for outperforming short sellers to some degree.

With those caveats in mind, the most heavily shorted stocks in the sample underperformed their lightly shorted brethren by an annualized 15.6%. And when money managers at large institutions pulled the trigger, the gap widened to a very significant 19.6%. Maybe we should pay more attention to those moves, then: There's gold in them thar hills!

Acting on the theory that a rapid rise in short-selling could lead the way to likely market underperformers or a very large percentage of a company's shares sitting on Wall Street's "pass line," we could end up with a list like this:

Company	Market Cap (Millions)	% of Shares Shorted	1-month Short Interest Change % Increase	CAPS Rating (Out of 5)
Sprint Nextel (NYSE: S)	$18,604	3%	79%	**
Sigma Designs (Nasdaq: SIGM)	$472	40%	15%	*****
Cree (Nasdaq: CREE)	$2,569	28%	14%	****
EMCORE (Nasdaq: EMKR)	$512	21%	142%	**
Western Digital (NYSE: WDC)	$6,141	10%	64%	****

Data from Capital IQ, a division of Standard & Poor's, April 22. CAPS ratings from Motley Fool CAPS.

These companies are listed for a variety of reasons:

• Sprint only has a modest 2.8% of its stock sold short, but that's a lot more than the 1.6% short interest reported a month ago.
• Sigma and Cree have large but relatively stable contingents of Negative Natties.
• EMCORE and Western Digital have both large and growing short interests.

I'm not saying that we should all go out and buy put options on all of these stocks today, nor that heavy shorting is an automatic ticket to penny-stock land. But if that many investors think there's something wrong with a business, with its direction, or with the current valuation, you should give some thought to their arguments. Our Motley Fool CAPS community can connect you to the pulse of the nation.

The word on Main Street
Sprint, for example, gets a comprehensive flogging from CAPS player Achughtai, who starts with the basics: "No business in US can survive without quality [customer] service and Sprint is the worst among its competitors."

All-star player ActiveValueFund make a compelling case about Cree's need for a partner:

... lacking the major partner needed in this increasingly commoditized business. They are trading at hype valuations. If the vertical integration doesn't work, they have risked major relationships with customers who feel that CREE is now directly competing with them.

According to The Journal of Finance, 13% of the average trading volume was short sales for the companies studied. It's dangerous to ignore the signs flashed by such a significant portion of the market, especially since those trades tend to work out really well for the institutions involved.

Also, nine of the 10 highest-rated CAPS players have made their way to the top on a mountain of "underperform" ratings, lending another ounce of credibility to a pessimistic portfolio strategy. Maybe you, too, should make your move when spring turns into autumn, or the pretty stock stumbles.

Further frumpy Foolishness:

• How to Short Stocks
• The Man Who's Shorting Buffett
• Thursday's Worst Stocks in the World
• Don't Just Blame the Shorts for Pulling the Market Down