One of the things that market-watchers like to watch is "short interest." When you short a stock (or some security), you borrow shares of it and sell them, aiming to buy them back and replace them at a later date, when they've fallen in value, as you expect them to do. So, shorting reflects bearish expectations about a stock, or even about the market.

In early August, overall short interest for the U.S. stock market was rising. That suggests that more investors are expecting a pullback, and that is likely because of the rally the market has enjoyed recently. (The S&P 500 is up around 42% in the last six months.)

Stocks, too
Other investors look to see which stocks are most heavily shorted, and they may conclude that those stocks are to be avoided because of the substantial negative expectations many people have for them. I'd caution you against that, though, because some of those shorted stocks may actually do well.

Think, too, about the basis of value investing, a style of investing favored by Warren Buffett, your friends at The Motley Fool, and many others. It's all about looking for a dollar selling for $0.50. And that means looking for out-of-favor stocks. Zeroing in on heavily shorted stocks will present you with unloved securities that you might want to research further.

Here, for example, are the five most shorted stocks in the S&P 500, along with their star ratings (out of five stars) in our Motley Fool CAPS community:

Company

CAPS Stars
(out of 5)

Shares Sold Short
(in Millions)

% of Share Float

Citigroup (NYSE:C)

**

625

8.7%

E*Trade Financial (NASDAQ:ETFC)

****

324

29.2%

Pfizer (NYSE:PFE)

****

254

3.8%

Merck (NYSE:MRK)

****

161

7.6%

General Electric (NYSE:GE)

****

152

1.5%

Source: Wall Street Journal.

Clearly, our community of investors (many thousands of them!) thinks there's some value and promise in four of them. Spending a little time in the CAPS community, I learned from member siebertl that E*Trade's CEO "requested that all of his 2008 and 2009 incentive compensation for ETFC be in the form of equity" -- which is a strong vote of confidence. Pfizer commentators noted its strong dividend, promising pipeline (from its Wyeth (NYSE:WYE) acquisition), solid fundamentals, and more. General Electric fans expect it to profit from an economic recovery and from its budding green technologies.

So don't dismiss shorted stocks. Just because some are betting against them doesn't mean that they're doomed to fail.

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Longtime Fool contributor Selena Maranjian owns shares of General Electric. Pfizer is a Motley Fool Inside Value recommendation. Try any of our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.