Do High Short Interest Stocks Beat the Market?
In the 1989 classic Back to the Future Part II, Biff steals Doc’s time machine car and goes back to 1955 where he gives his younger self a sports almanack. Knowing all the scores of all future games, Biff becomes incredibly rich.
Well, ladies and gentlemen, the script for Back to the Future 2021 edition has been written. All Biff from 2071 has to do is tell his 2021 self to sell everything he owns, open a Robinhood account, leverage his $10,000 savings out the nose (100x or so should do) and put everything on GameStop (GME) stock on January 12th, 2021 at $20 per share.
16 days later, GME’s stock crosses above $450 and his $10,000 leveraged investment will be worth $24 million. Biff can then sell his shares, pay some hefty short-term capital gains tax, and proceed to take over the entire town just like in the original movie.
If you do not have a time machine, well, then you’re stuck trying to figure out what the future holds.
If you were one of the lucky contestants to have also purchased GME stock, you are probably wondering whether now is a good time to lock in your profits or let it ride. And if you don’t own GME stock, you’ve probably heard all about it at this point and are wondering whether you should get in on the mania.
Well, we don’t have a time machine to the future, but we do have a time machine from the past. So let’s go back and see what stocks with high short interest (like GME) have done since 1987. That may offer you clues with what you should be doing right now.
But first, let’s do a quick review of what happened with GME stock.
What happened with GME stock?
If you don’t already know what happened to GME stock, this is a good old fashioned example of a “short squeeze”.
If you don’t know what a short squeeze is, let’s take one minute to explain.
Shorting a stock is basically the exact opposite of buying a stock. When you buy a stock and it goes up in price, you make money. When you short a stock and it goes up in price, you lose money.
The problem with shorting a stock is twofold:
Unlimited LossesIf you buy a stock, the worst thing that can happen is that it goes to $0. That’s bad, but you can only lose your initial investment. One problem with short selling is that there is no limit to what you can lose. If you spend $100,000 shorting a stock and it goes up 1x, you lose $100,000. If the stock goes up 2x, you lose $200,000. If the stock goes up as much as GME went up in January, you lose $1.7 million.
LeverageAnother problem is that short sellers borrow money to short their stocks. And when they lose enough money, the banks start calling and demand that get out of their positions. And, in this case, getting out of their negative positions requires a positive position (i.e.: they have to then buy the stock).
And when this starts happening at a grand scale, you get a short squeeze. Everyone that was short the stock now has to buy the stock, which drives the stock up even more. Then more short sellers are forced to buy the stock, which drives it up again. And then it becomes a full on mad dash with everyone trying to cover their shorts (i.e.: buy the stock).
And when this happens, shorting a stock can become like a literal financial black hole. In the month of January alone, short sellers lost a total of $19.75 billion.1
And all this carnage was caused by a bunch of rogue Robinhood traders on a subreddit called Wall Street Bets. They saw that there was an opportunity to essentially manufacture a short squeeze. So they coordinated their efforts and started buying GME stock, which pushed the price up. As more people bought, the stock price went up; which caused more short sellers to have to buy to cover their shorts; which caused the price to go up even more. Then we had this…
GME had the highest short interest in the entire US stock market as of January 1st, 2021. Nearly 140% of the shares outstanding were sold short. That’s right - more shares were short than even existed. How that happens is a topic for another day, but the point is that GME was the most popular short in the market. It was heavily bet against.
If you just look at January 2021 data, it seems obvious that buying stocks with high short interest is a good idea. To make money, you simply scan for the highest short interest stocks of the day.
Here is a list of all those stocks as of January 29, 2021.2 You can see that GME is still the highest short interest at over 120%.
High short interest
So - what does this mean for you? Should you buy GME and others on this list? Or is being on this list a bad thing for future returns? We’re going to take a look at short interest back to 1987 to see if the data gives us any clues what to do with stocks on this list.
To construct this study, I looked at monthly data going back to 1987. Every stock in the S&P 500 index was ranked by highest short interest relative to average daily volume. So the most shorted stock (like GME) would be ranked #1 and would get put into Bucket #1. The least shorted stock would be #500 and put into Bucket #10. For reference, both AAPL and AMZN were in the bottom 10 of this list3 - so think twice before you go betting against those. 😉
So - let’s say you would’ve made portfolios out of these lists each month starting in 1987. Let’s say you held onto each one of these buckets for 12 months. How would those buckets have done?
Well, the first Bucket - the one full of the highly shorted stocks - would have produced average returns of 8.38% per year. The last Bucket - the ones filled with low short interest stocks - would have generated 18.77% per year, on average.
So - the long-term evidence is clear: short money is smart money. And, intuitively, this makes sense. Short sellers tend to be large investors with tons of research firepower. When they short a stock, they are taking a lot of risk in doing it. That means they do a ton of research beforehand and, in most - but not all - cases, they are correct.
So, in summary, looking at short interest is a useful indicator for investors. If you’re considering buying a stock, first check how much of the shares outstanding are being shorted. If you see a big number, you should think twice before buying. There is a lot of smart money betting against it.
As for GME, if Biff were to have bought it on January 12th, 2021 - my prediction is that he would’ve sold it on January 25th at near $350. You should do your own research before buying or selling any security, but if I owned it right now, I would be selling. My prediction is that the stock trades for less than $50 by year-end 2021.
Disclaimer: This is not financial advice. Past performance is no guarantee of future results. This is not an offer to buy or sell any security. Do your own research before making investment decisions. Author does not own any position in the stocks mentioned nor does he plan to make any purchases within the next 48 hours.
Source: S3 Partners, a New York-based firm that tracks short positions on U.S. stocks. ↩
High Short Interest Stocks. https://www.highshortinterest.com/. Accessed 1 Feb. 2021. ↩
Source: S&P Global’s Compustat data from 12/31/1987 to 1/21/2021. ↩