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 tend to trend upward over the long term. But when you look at individual stocks, you'll find plenty that lose money over the long haul. According to hedge fund institution Blackstar Funds, even with dividends included, between 1983 and 2006, 64% of stocks underperformed the Russell 3000, a broad-scope market index.

A large influx of short-sellers shouldn't be a condemning factor for any company, but it could be a red flag from traders that something is off. Let's look at three companies that have seen a rapid increase in the number of shares sold short and see whether traders are blowing smoke or if their worry has some merit.

Source: The Wall Street Journal.

Covering the spread
Petroleum refiners are an interesting group of companies, because they represent the one aspect of the oil sector that can be left in the dust if oil prices rise or if the gap between West Texas Intermediate crude and Brent crude closes. For Alon USA Energy, a relatively small refiner in the South Central and Southwestern United States, both factors have crushed its earnings potential in recent months.

In the second quarter, Alon reported a gargantuan $11 sequential-quarter decline in WTI spreads despite announcing an all-time quarterly record per-day oil throughput. In other words, the demand for refined product is improving, and Alon USA's operations are becoming more efficient, but it's all coming when oil prices aren't cooperating.

The question here is whether those spreads will move back into Alon's favor anytime soon. To that end I'm not so sure. In addition, the cost of renewable identification numbers, which are essentially renewable credits, is also pushing Alon to diversify its product throughput to potentially lower-margin products. There's little doubt things are worsening, as its full-year earnings-per-share estimates have fallen from a projection of $1.07 next year to just $0.21 in three months.

Ultimately, Alon is trading for just a hair more than its book value and has a huge short interest position that could easily ignore a short-covering rally. The big question left to be answered is, "What will be the catalyst?" Right now I don't think anyone can answer that, which will likely keep short-sellers in charge of Alon over the interim.

Does this stock have the power to head higher?
On the surface it might be pretty difficult to understand why NRG Yield has attracted the ire of short-sellers. The company, a recent spinoff of NRG Energy (NRG 1.12%) that is comprised of alternative and traditional energy assets, sells its energy to utility companies for what looks like a steady cash-flow stream.

However, if you look back at just the past year or two, you'll recall that utilities have been left out in the cold while the rest of the market heads higher. The reason is that utilities are a defensive play that works well when there is market uncertainty. With the federal government shutdown resolved and a debt-ceiling solution in place for another four months, there might be no reason for NRG Yield to trade above $30 per share.

The answer as to who's right could lay somewhere in between. Short-sellers have to be keying in on NRG Yield's forward P/E of 33 which would certainly be a premium within the sector. If the market continues to march higher there probably isn't going to be a lot of support to buoy frothy utility share prices like NRG Yield's.

On the other hand, parent NRG Energy announced late last week that it was purchasing Edison Mission Energy from Edison International (EIX +0.56%) for $2.64 billion. How does this help NRG Yield? The bankrupt Edison Mission has 1,100 megawatts of wind power generating capacity that, along with 500 megawatts of traditional energy generating capacity, is likely to be sold to NRG Yield from NRG Energy. While costly up front, alternative energy is a long-term cheaper solution that should result in beefier margins for NRG Yield.

NRG Yield could honestly head either way at the moment, but this prospective deal and the likelihood of an impressive annual dividend make me lean toward the bull camp.

If you build it, short-sellers will stay away
With the prospect of interest rates rising soon and the threat of decreased U.S. GDP hurting consumer spending, short-sellers took it to do-it-yourself home improvement retailer Home Depot at the end of September.

Obviously, Home Depot can't go up in a straight line, and short-sellers know this. If interest rates were to rise, it would likely harm new-home sales, which should put a damper on Home Depot's growth rate.

But I'm going to take a different approach. I'd contend that within the housing sector Home Depot might be one of a handful of companies that could thrive in a rising interest rate, or slow GDP growth, environment. The reason, as we saw in 2010-2011, is that Home Depot also acts as a shopping ground for home remodels. If the economy turns lower or homeowners are unable to move, they'll just turn to the DIY home improvement store to freshen up their residences.

Another reason Home Depot appears likely to trump pessimists is its niche position in the DIY space. Even though Lowe's has delivered improving same-store comparisons right along with Home Depot, it's always been more reliant on appliance sales to drive its margins. This means that if the economy were to weaken, Lowe's margins would feel it in a much larger way than Home Depot.

Make no mistake: Home Depot is nowhere near as cheap as it's been in years past, but I wouldn't dare bet against this DIY powerhouse now.

Looking past the short term
This week's theme is really about looking past short-term share-price drivers and seeing what could send these three stocks higher. For Alon, even over the long run it's going to be dependent on oil spreads which will put short-sellers in control of its stock from time to time. NRG Yiel's potential access to a large wind farm could give it a reasonable edge to move its stock higher. Home Depot, meanwhile, continues to dominate the DIY space and looks to capitalize on both the contractor and individual homeowner side of the business.