Here’s what it means when ‘hated’ stocks outperform the market

“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%


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, according to FactSet, trailing only the 24.6% growth seen in the fourth quarter of 2017.

So that might mean the phenomenon has nearly run its course as a positive factor, but Thornton highlighted other interesting tidbits.

He notes that the median days-to-cover ratio for shorts in the Russell 3000 is at the “very low end of the range.” Days to cover is a way to measure short interest in a stock. It refers to the number of days it would take to close out all of the short positions in a stock based on average daily volume for those shares. In other words, investors aren’t making that many short bets.

That’s interesting, Thornton said, because the ratio tends to rise after growth slows and ahead of recessions. Since the median days-to-cover ratio isn’t rising, it “may be another indication that a recession isn’t exactly upon us,” he said.

Another encouraging sign for stock market bulls came from the retail industry, which is still a focus for short sellers, Thornton said. he noted that the average Wall Street analyst rating for the sector appears to have marked a bottom, “unbelievably close” to the Great Financial Crisis low.

Granted, the sector has already enjoyed a hefty rebound, with the SPDR S&P Retail ETF

XRT, +2.19%

 up around 14% from a year ago. But Thornton said the Street “has a tendency to be late,” leaving plenty of room for more upgrades and, presumably, gains.

That all might be soothing to stock-market bulls as the S&P 500

SPX, +0.45%

 and the Dow Jones Industrial Average

DJIA, +0.72%

 remain stuck in the range between the late-January record highs and the lows from the February selloff.

To quote Shakespeare: “How poor are they that have not patience! What wound did ever heal but by degrees?” Or as the internet might have him say: “Chillax, dude, it’s probably gonna be alright.”

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