Typically, by the time a stock has rebounded, it's probably too late for you to cash in on its rally. Market logic dictates that a soaring sock is inevitably bound to fall -- and if it's already peaking, it's going to happen sooner than later. But there's no rule of investing that can't be broken -- so a rallying stock may very well continue to defy gravity. But how do you know that the bubble won't blow up in your face?
Well, you don't. But the market behavior of more sophisticated traders can be a good litmus test.
Take short-sellers, for instance. They are among the most sophisticated types of investors, so it's worth having a look at what they're doing. When an investor "goes short," he's actually betting on his stock to lose; instead of buying low to sell high, he's selling high to buy low. A short-seller borrows shares from other investors and sells them on the open market. Sooner or later, he has to return them, and closes the short by buying back the same number of shares he initially borrowed. If he can buy back the stock at a lower price, he turns a profit off the difference.
Short-sellers take on unlimited risk because they have unlimited downside (theoretically, there's no upper limit on the stock's upside) -- if the stock keeps rising, they keep losing. For this reason, they tend to be quite a bit more sophisticated than the average investor -- so if they're shorting a stock, there's a pretty good chance that trouble lies ahead.
That said, if short-sellers cover their positions (i.e., buy back the borrowed shares), they think the upside potential of the stock outweighs the downside. This creates the potential for a short squeeze -- a scenario where demand from short-sellers pushes the stock price higher.
For this list, we wanted to identify the rebounding stocks that have crushed bearish short-sellers. All of the stocks mentioned below lagged the S&P 500 in 2010, but they've all outperformed the benchmark index in 2011. To refine the list, we looked at short-seller activity, and identified the rebounding stocks that have seen the largest decreases in short interest over the last month.
Short-sellers think these rebounding stocks have more upside than downside -- do you agree? (Click here to access free, interactive tools to analyze these ideas.)
1. GSI Commerce
2. The St. Joe Company
3. Warner Music Group
5. MB Financial
7. Century Aluminum
Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research. Note: The numbers on top of items represent the forward P/E ratio, if available.
Kapitall's Eben Esterhuizen does not own shares of any companies mentioned.