This is not a trend that bearish investors would love to see.
The most shorted stocks, which traders are betting the most against, have surged since the end of March according to the Thomson Reuters Most Shorted Index.
To short a company, a trader borrows its shares and sells them with the hope that after their price falls, they can be purchased more cheaply. The trader then profits from the difference between the higher sale price and the lower purchase price.
However, in June, their performance jumped to match a four-year high, according to index data compiled by the Financial Times. The index adds companies by short interest, or the quantity of outstanding shares sold short.
“The first thing that jumped out in our analysis was the skew toward small caps in the heavily shorted stock screen,” Michael Wilson, the chief US equity strategist at Morgan Stanley, said in a note on Monday.
This fact explains why the most-shorted stocks have been outperforming, and underscores Wilson’s recommendation for how an investor may profit from this trend.
Of course, hopping on stocks investors are betting against can end in tears. Short sellers, after all, can be among the first and loudest voices to flag company troubles, as Jim Chanos did with Enron and Citron’s Andrew Left did with Valeant Pharmaceuticals.
For now, however, the strength of small-caps is driving the most-shorted stocks higher and presents an opportunity, according to Wilson. For further proof that this is the case, Wilson observed that the Russell 2000, dominated by smaller companies, outperformed the large-cap S&P 500 by 450 basis points from the end of March, when the most-shorted stocks broke out, through late-June.
“The Thomson Reuters Index of Most Shorted US stocks has shown much greater relative performance vs the S&P than the Russell, reinforcing this point further,” Wilson said.
Separate from how small-caps are helping the most-shorted stocks, Wilson had other reasons to recommend this corner of the market to investors. The domestically focused companies are outperforming larger stocks this year, and they should be more shielded as trade tensions flare up, he said.
JPMorgan made a similar recommendation, describing small caps as a “catch-all trade” that benefits from reflation, tax cuts, and lower sensitivity to ongoing risk.
Wilson further observed that within small-caps, the heavily shorted stocks skew towards Consumer Discretionary — a sector he’s cautious on.
“We think continued strength in small caps may help these stocks generally, but we reiterate our Discretionary underweight,” Wilson said.
He’s skeptical that the lift to consumer spending from tax cuts will be sustainable. He added that, ahead of the busy summer driving season, gas prices have risen to levels that could erode about a third of the benefit of tax reform to the average family.
Conversely, small caps may have more outperformance ahead of them, given that relative earnings revisions have been stronger than performance, the dollar hasn’t weakened, and trade tensions persist, Wilson said.
“The relative upside is less than it was for given small cap outperformance, but to the extent they continue to work, commonly shorted stocks may continue to see some momentum.”
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