Back in September 2013, we first showed that perhaps the only solid alpha-generating strategy was going long the most shorted stocks in advance of a short squeeze. Since then, the cat has left the bag, and not only have investors scrambled to jump on the long side of the most hated names but there now is, as wereported a week ago, a short squeeze ETF (Ticker SQZZ).
The bigger problem, however, with observing this particular strategy and putting into the public domain, is that once everyone jumped on board the strat's profitability promptly evaporated, as can be seen in the following Goldman charts laying out the performance of the most shorted stocks relative to the Russell 3000.
Why have forced short squeezes lost their oomph? Goldman explains:
Shorts have weighed on investor performance during the current bull market. The average equity long/short hedge fund returned 2% in 2014, 12 percentage points less than the S&P 500, and has lagged the S&P 500 by an annual average of 9 pp during the six-year bull market since 2009. Sizing of short exposure and poor choice of shorts have been the major headwinds to returns, given that our Hedge Fund VIP list (Bloomberg: GSTHHVIP) of the most popular long positions has outperformed the S&P 500 by an average of 5 pp each year (22% vs. 17%) and 265 bp in 2014 (16.3% vs. 13.7%). However, a basket of the largest hedge fund short positions (GSTHVISP) returned 16%, also outperforming the S&P 500.
In other words, shorts have had enough of being trampled by those who are willing to take the other side of the trade only to force the "max pain" threshold on the shorters and to force a cover of bearish positions. Sure enough Goldman adds:
The most shorted stocks frequently present investors with large return opportunities, although those returns are often reaped by contrarians who are long the stocks rather than the investors shorting them. Of the 50 US stocks with market cap greater than $1 billion and the largest outstanding short interest as a share of cap at the start of 2015, nearly three-quarters (37 stocks) have posted YTD returns either 10 percentage points better or worse than the S&P 500.
Which is why there is now a short squeeze ETF.
Unfortunately for the likes of Goldman, the lack of squeezable shorts - and in a rigged, manipulated, artificial market only masochists would persist in holding on to unhegded/non-pair trade short positions - means there is no longer an ability to create a quick dime by pulling the rug out of any stock that has seen an accumulation of shorters and quickly cash out after yet another quick and outsized return.
Which is why Goldman is out with a note kindly reminding the muppets its clients that the market is massively overbought...
The S&P 500 index trades at a forward P/E of 17.2x, the highest level in the past 40 years outside of the Tech Bubble (see Exhibit 3). The median stock trades above 18x, ranking in the 99th historical percentile since 1976. Other metrics show a similar picture of stretched valuations, attracting investors looking for overvalued stocks that will prove especially profitable shorts should multiples revert toward historical averages.
... and one should put on shorts here. Which incidentally is precisely why hedge funds have underperformed the broader "market", in which central banks have eliminated all risk and thus the need for hedging, for 7 years in a row. From Goldman:
The rapid price adjustment of successful shorts suggests that most investors should diversify their short portfolios and rebalance them frequently. Most successful shorts re-price quickly to reflect the disclosure of negative news or weak fundamentals, the timing of which is often difficult to predict. These stocks also tend to exhibit high idiosyncratic risk prior to the arrival of the negative news. Because of these patterns, short investors should consider utilizing quantitatively-managed diversified portfolios in order to smooth returns.
Goldman then proceeds to show what the most shorted currently stocks are...
Exhibit 7 contains an objective screen of US stocks with the highest short interest as a share of float cap. The data below are compiled and released biweekly by the exchanges. The most heavily shorted stocks are generally characterized by the binary possibility of massive collapse or major success, and these stocks frequently go on to massively outperform their peers despite the opposite expectations of short investors.
... and concludes with a table in which it believes new shorts should pile into.
Exhibit 21 contains a list of 19 S&P 500 stocks that present the best opportunity for short alpha generation, in our view. First, these stocks are all likely to deviate from market and sector returns in the next six months, according to our model. In addition, these stocks are all rated Sell by Goldman Sachs Equity Research analysts, and have returns to their 12-month price targets1 at least 10 percentage points below the consensus return. We also exclude stocks with dividend yields above 5% or that our analysts have categorized as most likely (more than 30% probability) to experience M&A activity during the next 12 months.
Among these stocks, CELG, ORLY, RHT, and EQR also rank in the highest (most expensive) S&P 500 valuation quintile using the blended metrics in Exhibit 16. As discussed above, high valuation stocks typically lag their peers and should be especially vulnerable in coming months as US economic data firm. HST, CTL, and EQR are held more than 5 bp underweight by the average large-cap mutual fund, another possible indicator of future underperformance as discussed above.
Of course, since one should always do the opposite of what Goldman recommends (because that is what Goldman itself is trading), the following is a perfectly suitable, and free, substitute of the SQZZ ETF: all one needs to do is go long the stocks Goldman recommends to short, and wait as the money comes in.
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Oh, and since Goldman is a master of dodecatuple reverse psychology, it realizes one could also go long the most shorted names precisely in anticipation of a squeeze. As such it even has a list of which "shortable" names to go long in expectation of a jump.
While most client inquiries recently have focused on short ideas, many of the approaches used in this report may also help identify potential long investment opportunities.Exhibit 22 below displays 13 S&P 500 stocks with above-average expected return dispersion and valuations below sector peers. These stocks are also all Buy-rated by Goldman Sachs Equity Research analysts and have returns to their price targets at least five percentage points above the consensus return. Of these stocks, only GM is held 5 bp or more underweight by the average large-cap mutual fund. VLO is on the Americas Conviction List.
Hint: pair trade the longs from the "short these names" table shown previously, with shorts derived from the list of names Goldman urges you to buy.