Shorts Are Piling Into These Stocks. Should You Be Worried?

The best thing about the stock market is that you can make money in either direction. Historically, stock indexes have tended to trend up over the long term. But when you look at individual stocks, you’ll find plenty of stocks that lose money over the long haul. According to hedge fund institution Blackstar Funds, even with dividends included, between 1983 and 2006, 64% (nearly two-thirds) of stocks underperformed the Russell 3000, a broad-scope market index.

A large influx of short-sellers shouldn’t be a damning factor to any company, but it could be a red flag from traders that something may not be as cut-and-dried as it appears. Let’s take a look at three companies that have seen a rapid increase in the amount of shares sold short and see if traders are blowing smoke or if their worry could have some merit.

Whack-a-bank
Almost indiscriminately of late, short-sellers have been battering financial companies based on weakening growth in the U.S. and worries revolving around Europe’s sovereign debt crisis. Now we can add another concern to the list. Friday, on behalf of the U.S. government, the Federal Housing Finance Agency filed lawsuits against 17 banks that purportedly sold what turned out to be toxic assets to Fannie Mae and Freddie Mac during the credit crisis. Named in the lawsuits are dunce-cap candidates Bank of America (NYSE: BAC) and its now-subsidiary Countrywide Financial, as well as other major U.S. banks Citigroup (NYSE: C) and JPMorgan Chase (NYSE: JPM).

Surprisingly, Wells Fargo has attracted short-sellers’ ire.  Wells Fargo boasts one of the more conservative loan portfolios of the major U.S. banks and reported a 54% drop in credit loss provisions in its most recent quarter. Although revenue growth has slowed, it appears more financially sound than many of its peers. Short-sellers could be barking up the wrong tree here.

I SPY an opportunity?
I’ll be the first person to admit I was glad our never-ending uptrend finally was met with a correction. Corrections are a healthy part of investing and they allow us to buy back into some of our favorite names at a bargain.  So I have to wonder, are investors emotionally dog-piling the major U.S. indexes, the SPDR Trust and the Dow Jones Industrial Average (INDEX: ^DJI), without any major justification?

In part, I have to say yes. These large intraday point swings and a rising volatility index are likely indications that emotional trading is present. But there are also clear indications that economic growth is slowing -- jobs figures, anyone? With that being said, the jury remains out on whether this will be a winning bet for short-sellers, but the long-term trend says they should tread lightly.

House of cards
It’s the most dreaded time of year for Hovnanian shareholders -- earnings time. With the company slated to report tomorrow, Hovnanian shareholders are still suffering the pangs and scars from last quarter’s earnings results. Here’s a short recap: there was a double-digit revenue decline, homebuilding gross margins dipped by 250 basis points, contract backlog fell, cancellation rates rose, and the company burned more precious cash.

Looking forward, I can see how investors could be upbeat, because there’s not much that Hovnanian can report this week that can be worse than last quarter. Even so, with losses mounting, cash dwindling, and the government looking to potentially cut back on homebuying perks, I think the shorts will own this stock for some time to come.

Foolish roundup
We've looked at three possible investments directly tied to economic growth -- with three different results. As always, with increased volatility, companies that manage their money more conservatively are less likely to be affected by large influxes of short-sellers.

What’s your take on these three companies? Do the shorts have it correct, or are they blowing smoke? Share your thoughts in the comments section below and consider adding Wells Fargo, SPDR Trust, and Hovnanian to your stock watchlist.