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 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 may not be as cut-and-dried as it appears. 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.

Company

Short Increase Aug. 15 to Aug. 30

Short Shares As a % of Float

SPDR S&P Homebuilders ETF

88%

N/A

Abercrombie & Fitch

54.1%

9.8%

Novartis

114.1%

0.1%

Source: The Wall Street Journal. N/A = ETFs do not have a fixed number of shares outstanding.


An "interesting" move
There are few sectors with more on the line when it comes to rising interest rates than the homebuilding industry. Historically low interest rates have been a driving force behind new homes purchases as well as home refinancing's which led to a surge in home remodels. However, the possibility that the Federal Reserve may soon take away its monthly bond-buying program throws into serious doubt the possibility of rates staying anywhere near their record lows.

The SPDR S&P Homebuilders ETF is actually a nice blend of homebuilding stocks as well as the product and appliance makers that are directly involved in the home improvement process -- think Home Depot, Lumber Liquidators, and Whirlpool. Still, with 25% of the index made up of homebuilders and another significant chunk made up of material supplies to the homebuilding industry, I can't help thinking this index is overly exposed to rising interest rate pressure.

Over the past 18 weeks, mortgage applications have fallen in all but three weeks and now sit 59% off their early May highs. Recent data from homebuilders may not factor in this rapid decline in mortgage originations, but you can rest assured that when third- and fourth-quarter results for homebuilders roll around they'll more than likely be well below the Street's estimates. As the Fed's tapering decision looms large, look for short-sellers to grab ahold of this ETF.

Abercrombie gets taken back to school
It has been a back-to-school season to forget for teen retailers this year. Consumers have made it very clear that only the deepest discounts are going to persuade them to make purchases, causing the teen trio of Aeropostale, American Eagle Outfitters , and Abercrombie & Fitch to lower their guidance throughout the remainder of their fiscal year. Unfortunately for invesotrs, only one of these retailers really looks like a solid buy at the moment, and it's not Abercrombie & Fitch.

American Eagle Outfitters is the only teen retailer worth considering here, because it balances the perfect niche of name-brand merchandise with mid-tier price points. In other words, Aeropostale has the association attached to it of being a discounted brand. On the other hand, Abercrombie is overly pricey relative to the similar styles offered between it and American Eagle. With American Eagle you get the best of both worlds and a much beefier dividend yield to top it off.

As for Abercrombie, it's going to continue to deal with the PR fallout from ongoing controversies with its CEO Mike Jeffries as well as struggle overseas in Europe where it's focused most of its expansionary efforts. Until Abercrombie can adequately remove itself from controversy and can instill a higher sense of value in consumers it's probably going to lag its peers.

Is this a cause for concern?
I wouldn't normally call 0.1% short interest much cause for concern, but given the 114% spike in short interest over the previous two-week period and the news that accompanied that spike, I'd say a deeper dive is in order.

The news that really appears to have short-sellers in an uproar is in Novartis notifying the Food and Drug Administration that a patient taking its multiple sclerosis drug Gilenya developed progressive multifocal leukoencephalopathy, or PML. Novartis was quick to retort, though, that in 71,000 previous patients treated with Gilenya none had developed PML, and that MS itself lends patients to a higher risk of developing PML to begin with.

Instead of focusing on one patient developing PML which may or may not have anything to do with Gilenya, I'd say Novartis investors and short-sellers need to keep their eye on two things. One is whether or not Gilenya gets eaten alive by Biogen Idec's Tecfidera. The real knock against Gilenya is that its safety profile isn't as favorable as Biogen's Tecfidera. While the two MS-relapsing drugs share similar side-effect characteristics, Gilenya was also shown in rare instances to slow a patient's heart rate which can lead to cardiovascular problems. There's a decent chance that Tecfidera could run away from its peers in treating relapsing MS.

But, before you pack your bags and hand Novartis over to the short-sellers, keep in mind that Novartis is among the biggest beneficiaries of the FDA's new breakthrough therapy designation. With a hand in three separate drugs currently with the breakthrough designation -- LDK378 and serelaxin which it's helping develop and Pfizer's palbociclib which is given with Novartis' Femara -- Novartis could be sitting on another $6 billion-plus in peak sales in its rapidly developing pipeline. There could always be some intermediate weakness with Novartis, but this is not a stock that I feel short-sellers would be wise to bet against over the long run.

Foolish roundup
This week's theme is all about differentiable factors. For homebuilding and home improvement companies they really don't have any outlets that would allow them to rise above a higher interest rate scenario. Similarly, with Abercrombie it's numerous PR gaffes have lost it the value previously perceived by its core customer. Novartis, though, has a deep pipeline in its back pocket which makes betting against this pharmaceutical name probably not the best idea.

If there's one stock that short-sellers would be smart to avoid, it just might be The Motley Fool's chief investment officer's No. 1 stock selection for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.

The article Shorts Are Piling Into These Stocks. Should You Be Worried? originally appeared on Fool.com.

Fool contributor  Sean Williams  has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle  @TMFUltraLong . The Motley Fool owns shares of, and recommends Lumber Liquidators. It also recommends Home Depot. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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