The Most Shorted Stocks

Every time the stock market rallies over any significant period, we're bound to see the "most shorted stocks" chart come out of the woodwork with an ominous caption like "presented without comment" or "this is the top." Besides the fact that presented without comment is a comment in and of itself, the presenter very rarely tells us the methodology behind the chart's construction, leaving us with more questions than answers.

This week's version is brought to us by Zerohedge. What we see presented in the chart is the "most shorted" stocks hitting new 10+ year highs and its relative strength index hitting its highest overbought reading ever. Although the article is short and the chart's construction unexplained, Zerohedge is ultimately trying to make the point that the market is nearing an inflection point because the crappiest stocks in the market are rallying while the Dow is down seven days in a row. (See also: Hedge Funds Bet Against These 10 Stocks the Most.)

Putting aside the lack of evidence supporting the argument, let's assume Zerohedge is right. We're seeing a massive short squeeze in the worst stocks, and that can't last forever, because nothing ever does. The problem is that the analysts haven't told us what to do with this information. How do we know when it's going to end, and when it does, how do we take advantage of it?

It's the same thing we see with the several pundits who have been predicting the next bubble in financial assets for the past 10 years. If they're so certain that something is happening right in front of their eyes, why are they so fixated on attempting to predict its reversal rather than profit from what's actually happening now (or better yet, participate and then reverse their position when their doomsday scenario begins)?

These types of charts make for a good headline, but at the end of the day, they don't make anyone money, especially when used like this. We can either trade the market we have or position ourselves for the one we've imagined and complain about why reality differs from our predicted outcome. Those using these charts/headlines are likely in the latter group.

The only thing the chart above tells us is that it's hard to short stocks in a bull market. So rather than sit here and complain about the most shorted stocks rallying, we can recognize that behavior and take advantage of it when it's combined with other technical factors like we saw in Advanced Micro Devices, Inc. (AMD).

The Bottom Line

We're here to make money in the market, not be philosophical or "right" about anything. Rather than sit around and debate what this move in the market's crappiest stocks means, why it's happening or when it's going to reverse, we can recognize and profit from it. We're in a secular bull market, so let's keep it simple and trade in the direction of the underlying trend. The most shorted stocks are ripping because it's hard to short stocks in a bull market. And yes, eventually, this short-term acceleration of trend in the "most shorted" stocks and the long-term bullish trend in the broader market will both end, but history would suggest that we are better served by continuing to position ourselves to profit from them until they stop working, rather than trying to predict when they'll reverse.

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