Short-selling induces 'junk stock rally'

NEW YORK -- Americans are cutting back on luxuries, but you wouldn't know it from the shares of boat retailer MarineMax. This seller of tiny Boston Whalers and 100-foot Hatteras yachts hasn't made a dime in two years, and analysts don't expect it to do so for at least another.

Yet, shares of the company have nearly quintupled in the past year.

If that seems odd, wait until you hear one reaso: Too many people are trying to push the share price down.

Investors who are bearish on MarineMax, called short sellers, have borrowed its shares from brokers and sold them, pocketing the proceeds. They eventually have to buy the shares back and return them to the brokers. Their hope is that the price will have fallen by then so they can make a profit.

The problem is, MarineMax stock has gone up, not down, in the past seven months. That means short sellers are facing losses, not profits, and are under pressure to quickly unwind the transactions to limit future losses. To do that, they have to buy shares, which can push the share price up even more.

It's called a short squeeze, and though many Americans don't know such a thing exists, much less understand it, it's driving up many stocks.

That's a worrisome sign. A market where stock prices are rising is generally good, but not if it's because of technicalities like squeezes that could peter out, sending prices down and walloping investors who bought while they were climbing.

"People call it the junk stock rally," says Paul Hickey, co-founder of researcher Bespoke Investments, referring to the market's remarkable rise since the March lows last year. "Companies most heavily shorted have done the best."

According to Bespoke, the 50companies in the Standard & Poor's 500 with the highest concentration of shares held by short sellers rose 59.6 percent last year versus 23.5 percent for the entire index.

Some losers proving winners in this Alice-in-Wonderland market include:

Struggling Harley-Davidson.

Airliners facing record losses.

Starwoods Hotels & Resorts, whose earnings per share sank 35 percent in the third quarter.

Homebuilders grappling with record low construction starts.

The parent of supermarket A&P, which hasn't turned an annual profit in two years.

Clothes chain Talbots, which hasn't turned an annual profit in three years.

Of course, stocks overall have surged since March mainly because of improved business prospects, not short squeezes. And it's impossible to know how much squeezes are pushing up individual shares. But chatter on Internet bulletin boards, griping by hedge funds on the losing end of squeezes and some curious stock moves suggest a lot.

The Sears experience

After Sears Holdings announced in early January that fourth-quarter results would probably come in better than expected, the stock didn't just rise, it leaped - up 12 percent in a single day. The stock is now more than double its level of a year ago.

To be sure, Sears stock was arguably beaten down too far in March when capitalism itself seemed in danger of extinction. The shares were trading at $34 then, down from $100 just six months earlier.

But Sears isn't exactly posting terrific numbers. Profit is expected to fall in its fiscal year ending Jan. 30. Ditto for revenue. Market share? Rivals have been stealing customers from Sears stores and its Kmart chain for years. Same-store sales, or sales from stores open at least a year? They're falling, too.

One possible reason for the jump: A third of Sears stock available for trading, or its float, is held by people who hate it - short sellers who've been scrambling to buy it lately.

Sears won't comment.

Bitten by Crocs

Time and again, shorts who correctly analyzed companies' prospects lose big anyway.

They were right on Crocs, for instance. Shares of the maker of the eponymous plastic shoes fell from $69 in October 2007 to a low of $1 last spring. The problem was they didn't go straight down and stay down. So anyone who sold the shares short near that low hoping the company would go out of business lost big as they rallied to a recent $7.51.

"These one-trick pony companies always end up in tears, and the shorts eventually are right," says Ivan Feinseth, who runs New York-based hedge fund Alpha Works and who sells stocks short as well as long. "But there's a lot of pain along the way."

Aversion to bubbles

Short-sellers were early and loud critics of the dotcom bubble, the housing bubble and the consumer credit bubble. Now some are complaining about a Bernanke bubble. Federal Reserve Chairman Ben Bernanke has pumped so much money into the markets, the argument goes, that even the worst-run companies are getting rewarded.

Whether good ones are also getting pushed up now by shorts is unclear. But they do occasionally have a big effect on the overall market.

Amid the stock selloff of late 2008 the Dow Jones industrial average actually rose hundreds of points on several days thanks partly to squeezes.

But the worst time for shorts recently, and one that resembles what is happening today, was 2003. The Feds reduced the overnight bank lending rate to 1 percent, helping to drive people frustrated with paltry yields on money market funds and other low-yielding investments into the stock market.

The S&P 500 returned 29percent that year, and even low-quality stocks targeted by shorts got swept up in the rising tide. A famous short-selling fund at the time, Rocker Partners, reportedly lost 36 percent that year.

Out on a limb

Shorts are even more vulnerable now. Shares held short at the start of the year made up 3.4 percent of total New York Stock Exchange shares outstanding versus 2.2percent at the start of 2003, according to Bespoke.

Short holdings peaked at 4.9 percent in July 2008 before regulators temporarily halted some short selling out of fear they were unfairly targeting banks.

Another big target of shorts now? Netflix, whose shares are up 69 percent over the past year, and Lululemon Athletica, a chain that sells yoga clothes and accessories. The latter's stock, held 14 percent by shorts, has quintupled in a year.

Unlike a lot of short targets these days, profits atLulu are growing - up 59 percent in the third quarter. Among their products: stretchy yoga pants for $98 and $48 T-shirts made partly from seaweed.

The shorts argue Lulu will have to sell a lot more of those pricey products to justify the rich 31 times expected earnings that the stock is trading at now. And that's not likely, what with the unemployment rate at 10 percent and the economy sputtering.

They may be right, but they could lose their seaweed shirts. Lulu bulls writing on a Yahoo bulletin board cite a compelling reason for thinking the stock has further to climb: The shorts are being forced to buy.