Who could forget GameStop or AMC blasting higher in 2021? One of the main drivers of those outsized moves was a short squeeze, which is what can happen when short sellers who are betting against a stock get caught in a wrong-way position.
One stock that Wall Street is bearish on now is Upstart Holdings (UPST -1.25%). Upstart has come under scrutiny this year as demand for consumer loans has fallen. Many investors have a negative outlook on Upstart for the near future, but its prospects are bright. Here's why this short-squeeze candidate could actually work out in the long run.
How short squeezes on stocks happen -- and what you should look for
Investors who bet against a stock borrow the shares and sell them. They hope to buy back the shares at a lower price to return to the owner, pocketing the difference as profit. But if the shares rise instead of fall, they may have to buy back the shares at a higher price to limit their losses, pushing a stock price up even higher and forcing other short sellers to close their positions. When too many investors get caught short on a specific stock, the resulting short squeeze can result in astronomical moves, like the 1,063% increase of GameStop in January 2021.
One way to track how many investors are short on a stock is called the short percentage of float. Float is the number of shares that are available for public trading. The short percentage of float is the number of shares sold short divided by the stock float. A short percentage of float of 20% or more is considered to be high, making a stock a prime candidate for a potential short squeeze.
Upstart's percent of float short sits at about 35%, making it an excellent candidate for a short squeeze. You should keep in mind that heavily shorted stocks usually are heavily shorted for a reason. Investors likely have a good reason to believe a stock could go down, which you must consider when investing.
UPST Percent of Float Short data by YCharts.
Here's why investors turned bearish on Upstart
Upstart's mission is to remake the lending industry, which shuts out countless people based on widely used risk models. Upstart argues that the traditional lending system, based on Fair Issac's FICO scoring system, considers fewer variables and makes it more difficult for some people to get loans.
Upstart uses its home-grown risk model, which incorporates 1,500 data points and runs through its artificial intelligence algorithm to assess the risk of default and fraud. According to its management, Upstart's scoring model can more precisely separate high-risk and low-risk borrowers than FICO.
The company partners with banks that originate these loans and makes money on referral fees paid by banking partners for every loan made through its platform. Those bank partners will hold some loans on their books while selling the remainder to investors in the market. Upstart enjoyed success last year as low interest rates, a stable economy, and few borrowers defaulting seemingly validated its lending model. The story has changed this year. Inflation is high, and the Federal Reserve is trying to bring it down. To do so, the Fed has raised its federal funds rate from near-zero to about 4.5% -- the fastest pace of rate increases in decades.
Investors have balked this year at buying Upstart's loans for a couple of reasons. One, those investors face higher costs of investment capital. They may not think these loans are worth the risk because Upstart's lending model is still relatively untested in a credit cycle downturn. Second, a lack of borrower demand for credit has hurt it. It has seen fewer loan applications during the third quarter while loan defaults ticked up. As a result, Upstart has tightened its lending standards.
This could set off a short squeeze in Upstart
The stock will likely face more volatility as uncertainty about the economy lingers in investors' minds. Many experts expect a recession in the next 24 months, so it will be interesting to see how Upstart's lending models perform during that time.
However, I think Upstart will ultimately emerge from the downturn stronger. The company will have more data in a tough lending environment. As it integrates this data into its lending models, those models should become more robust, giving Upstart and its banking partners more confidence in the loans they extend.
Upstart is also building out other lending segments, including auto and small business loans, which should be another long-term growth driver for the fintech. I'm looking for interest rates to stop rising and a more favorable economic backdrop, which could propel Upstart higher and set off a short squeeze on those bearish investors in the process.
