Hedge fund managers have outsmarted themselves again…
Ever since the market’s improbable post-election rally, the smart money just can’t catch a break.
For the past couple months, we’ve experienced a low-correlation market. That’s supposed to be the perfect environment for picking stocks.
But here’s the catch – you have to pick the right ones.
If you bet big against a basket of stocks that rips higher, you’re gonna have a bad time. So far in 2017, this has been the fate of the so-called smartest guys in the room…
“The 50 stocks in the S&P 500 that hedge funds are shorting most often rallied 6% last month, while the benchmark index itself rose just 1.8%,” The Wall Street Journal explains. “It’s the continuation of a brutal trend. Last year, the 50 stocks that show up the most frequently in hedge fund short books rose 37%, the biggest wrong-way move since Credit Suisse began tabulating the data in 2013.”
Talk about a punch to the gut…
Some of the most hated stocks on the market have the potential to dump a barrel of rocket fuel on the rally. They’re already outperforming the major averages. Now they have the potential to spark the market’s next big move higher.
Here’s how it works:
Anyone who shorts a stock “borrows” that stock from a broker. And if the trade moves against them, they actually have to buy the stock to close out their position. That’s why it’s called a “short squeeze.” They literally get squeezed out of the trade. If their losses mount quickly the selling is more ferocious.
What happens when all these short-sellers are forced to buy the stock? That drives its price even higher. The exact opposite of what the short-sellers wanted.
Want to see a short squeeze in action? Just check out the action in Tesla Inc. (NASDAQ:TSLA) since early December:
Tesla shares had been stuck in a funk for much of 2016. Most short sellers felt safe betting against this expensive, hyped stock that couldn’t seem to get much traction in the markets. According to the most recent market data, nearly 30% of Tesla’s available shares are sold short.
That’s one of the main forces that helped turn a quick move off its December lows into a furious rally of more than 40% in just two months.
When we last hopped on some short squeeze plays like these in 2016, NYSE short interest was near its historical record highs of 2008. That helped stretch the already-powerful market rally off the bottom—and put some serious gains in your pocket.
If we see the major averages begin to break out of their sideways ranges, we could be in for a massive short squeeze in the coming weeks. If hedge funds continue to end up on the wrong side of the boat, a short covering rally could be the fuel the stock market needs to clear the air and make that next push higher.
Of course, there’s plenty of rapid-fire gains heading our way if and when this big squeeze plays out. But this environment won’t last forever. We have to stay on top of these squeezy stocks and grab onto these big moves while we can…
This story originally appeared in the Daily Reckoning