“Love me or hate me, both are in my favor,” is part of a quote often incorrectly attributed to William Shakespeare. But even though the bard never said it, the sentiment appears to hold true for the stock market, at least for now.
“There are generally two types of stocks populating the list of this year’s best performers — loved growth stories like [Abiomed ABMD, +3.46% and Netflix NFLX, +0.52% ] and hated stories like [Chipotle CMG, +1.19% TripAdvisor TRIP, +1.70% and UnderArmour UAA, +6.32% ], where a combination of stable to up estimates and huge short interest have resulted in powerful gains. But strength in heavily shorted names does go beyond a few anecdotes,” wrote T.J. Thornton, a managing director at Jefferies, in a weekend note.
Jefferies took a look at the Russell 3000 RUA, +0.47% a broad market index that tracks around 98% of U.S. equities, and found that the most shorted names are on track for a second straight quarter of outperformance versus least shorted stocks (see chart below).
Investors can short a stock — a bet that its price will go down — by borrowing shares and then selling them with the hope of buying them back later at a lower price. If the stock rises, however, it can force short sellers to scramble to buy back the shares and close out their positions, further fueling a rise in price.
History shows that outperformance by heavily shorted stocks tends not to last very long but does usually occur when overall earnings growth takes a leg higher, which Thornton notes is exactly what has happened lately.
With second-quarter earnings season virtually in the books, S&P 500 companies saw estimated earnings growth of 18.9%, which would be the second highest since the first quarter of 2011,