November 25, 2002 , page 192
AGAINST THE GRAIN
A Short Path to Trouble
Beware of analysts touting stocks that may get 'squeezed' higher. That's a loser's game.
Call it a sign of desperation, or just a sign of the times: One of the most popular games from the bad old days of a few years ago, squeezing the short-sellers, is back in vogue as a reason to buy stocks. Consider these examples from recent weeks. Goldman Sachs analyst Steve Kent reiterated his love affair with Marriott by writing that "a 'short squeeze' may be imminent." Morgan Stanley analyst Mark Edelstone cited a "large short position" as part of his recent pitch for Silicon Laboratories, a maker of cellphone components. And despite a tumble in the price of Nautilus, which makes the Bowflex exercise machine, Eric Wold of RTX Securities said a "potential short-squeeze situation" could pump up the stock.
Yet squeezing shorts is anything but a sure-fire way to make money. A short squeeze, for the most part, occurs in heavily shorted stocks when short-sellers are forced to cover (buy back the shares that they have sold) because long investors are bidding the stock up. (Shorts bet against stocks by borrowing shares and selling them, with the hope of buying them back at a lower price.) The fast-rising prices force shorts to buy shares quickly, which makes the stock soar. That forces even more short-covering, creating the squeeze.
What could cause this chain reaction? The rightful owners of the shares, often institutional holders like mutual funds, might demand them back, often in an effort to cause a squeeze. Or the short-sellers might have been premature, or perhaps they misjudged the fundamentals. (It does happen.) Or maybe the shorts panic on the release of what looks to be good news. However, for all but the nimblest traders, squeezes can be a big loss waiting to happen. "Playing a short squeeze," says Barry L. Ritholtz, chief market strategist for the Maxim Group, "is a game for only the very brave and very stupid." There is, after all, no guarantee a squeeze will happen. Even if one does occur, and the fundamentals prove to be as bad as the shorts had claimed, the slide back down can be faster than the rise. What proponents of short squeezes often forget is that short-sellers have a natural incentive (their own profit-taking) to buy a falling stock. When they're gone, or squeezed out, that buying cushion disappears and squeezed stocks often land with a thud.
Just ask anybody trapped in the squeeze of Calpine, an independent power company whose stock was catapulted from $45 to as high as $57 on a short squeeze in March and April 2001, before fundamentals caught up with the story; it now trades at around $3. But the ultimate risk for investors hoping for a quick profit is that they get lured into the end of a frenzied run-up--like the ones that boosted the stocks of circuitboard-maker Act Manufacturing, software maker Lernout & Hauspie, or auto transport company ACLN, which at their peaks traded at $72, $73, and $50, respectively. Act Manufacturing has since filed for bankruptcy and fetches less than a penny on the pink sheets after being delisted by Nasdaq. ACLN, accused by federal securities regulators of fraud, was booted from the New York Stock Exchange and trades for less than a quarter on the pink sheets. And Lernout & Hauspie has been liquidated.
At the least, those playing the squeeze should entertain the notion that shorts might be right. According to a recent study published by the Journal of Finance, the higher the short interest, the more likely a company is to fall. Heavily shorted stocks "experience a significantly higher incidence of liquidations or forced delistings" than similar-sized firms with low short interest, the report says. "Large short positions are bearish signals."
Which brings us back to Marriott, Silicon Labs, and Nautilus, all magnets for shorts. Marriott, the shorts believe, suffers from a mix of bad business conditions as well as aggressive accounting and too-close-for-comfort dealings with related parties. While conceding that business is weak, as it is for most hotel operators, Marriott insists that its accounting and related party dealings are appropriate. The knock on Silicon Labs, meanwhile, is that it's facing tough competition. The proof is in the numbers: Fourth-quarter revenue growth, based on the company's guidance, is tumbling. Finally, the shorts are betting Nautilus (a company I've written about on The Street.com for months) will suffer as demand for the Bowflex, its main product, weakens. Its stock tumbled 43% on Oct. 16 after the company warned of a possible slowdown, yet some Nautilus fans are counting on a squeeze to reinflate the stock. Maybe they'll get their wish, but if the shorts wind up being right about any of these companies, investors playing for a squeeze may instead wind up getting squashed.