They’re frequently called everything from spoilsports to saboteurs. But short sellers–who borrow shares of stock to sell with hopes of buying back at a lower price–do provide valuable liquidity to markets, as well as a healthy counterpoint to the typically rosy claims of management.
Utility stocks aren’t historically known for high levels of short selling. That’s in large part because of the steady nature of their essential services businesses, but also because short sellers must make good on dividends as long as they hold a stock short.
That prospective cash drain has also historically been a major disincentive to shorting other high-yielding stocks. In recent weeks, however, short interest for a wide range of dividend payers has risen, including in sectors not known for volatility.
Short interest as a percentage of total shares of stock outstanding has risen especially sharply in the US Communications sector. For example, Frontier Communications Corp (NYSE: FTR) has short volume equivalent to more than 21 percent of its shares outstanding. And a half-dozen other sector companies have percentages of 10 percent and more.
Just as buyers of stock hope share prices will rise, short sellers are betting prices will drop. And to be sure, there’s some logic to these elevated short levels now.
First, the US economy has hardly been running on all cylinders in recent years. And indications are growing that austerity may take a greater bite out of economic growth this year than most expect.
Several major retailers, for example, are reporting a drop in sales so far in 2013, as consumers absorb the bite of a 2 percentage point increase in Social Security taxes. Moreover, we’re barely a week away from the sequester’s dramatic cuts in government spending.
Thousands of workers have already been furloughed without pay in affected industries. And barring a last-minute compromise between politicians in Washington, the worst is almost surely yet to come.
The prospect of softer economic growth means we’re almost certain to see more stress on companies’ finances, which in turn raises the odds of dividend cuts. And as we’ve seen time and again, a dividend cut almost always drives a stock’s share price lower.
The second reason for elevated short interest is fear. In last week’s Utility & Income, I highlighted CenturyLink’s (NYSE: CTL) Valentine’s Day “gift” to its shareholders: a dividend cut of roughly 26 percent that triggered a one-day drop of equivalent magnitude.
CenturyLink’s stock has a market capitalization of about $22 billion, so its action was taken to have wider implications, both within the communications sector as well as other industries. The result has been selling momentum that’s effectively fed on itself, driving down prices even for stocks of companies that have not cut dividends.
That means investors have been able to make money shorting high-yield stocks over the past week, even when they’ve been wrong about the vulnerability of the underlying company’s dividend. That was the case for two other high-yielding telecoms reporting numbers this week, Frontier Communications and Windstream Corp (NYSE: WIN).
Both stocks took sizable hits following CenturyLink’s dividend cut, due to speculation their dividends would be cut next. Both, however, reported numbers this week that supported their dividends, and their management teams vehemently asserted payouts will continue at current levels well into the future.
Weight of Evidence
In the near term, the stock market is a popularity contest. And the greater the level of emotion, the more volatile share prices can get, on both the upside and downside.
Long term, however, it’s a weighing machine. And if we learned anything from the 2008-09 crash, it’s that even the worst damage to stocks will reverse, as long as underlying companies remain viable.
If history is any guide, today’s economic stress tests will claim at least some victims in the high-yield universe. And when dividends are cut, we’re likely to see steep share price declines, for both the actual cutter and other companies deemed by investors to be at risk.
The Communications sector has proved to be a vulnerable area in the past, as market power continues to consolidate in the hands of the industry’s largest players. And it remains an area to watch carefully.
Energy production is another sector where some dividends may be at risk this year. Mainly, there’s not enough infrastructure to get surging oil and gas output to places where the price will reflect global markets. That’s created price differentials between regions, which are starting to take a bite out of cash flow of some producers.
Even in 2008-09, however, the vast majority of dividend-paying companies did not falter. And while investor skepticism dragged down share prices for a while, they did eventually recover when conditions inevitably improved.
As bad as things might get this year, they’re not going to be as bad as they were at the height of the Great Recession. That’s mainly because corporations and individuals are far less indebted now than then, and such massive declines are only possible when enough folks are leaning in the wrong direction.
That means the vast majority of the dividend-paying stocks being shorted today are likely to recover the ground they’ve lost in recent weeks. If anything, the plight of the short seller is particularly treacherous. If momentum suddenly shifts, they can be caught in what’s known as a “short squeeze.” That’s when short sellers are forced to buy back the shares they’ve sold short in order to close out their positions. As successive waves of short sellers cover their positions, they drive stocks even higher, forcing other short sellers to pay even more to close out positions, which magnifies losses.
When short volume for a stock reaches 10 percent or more of shares outstanding, it reflects a great deal of pessimism for a company’s prospects. But it also doesn’t leave shorts a lot of room to easily close out positions if they turn out to be wrong. And those are ideal conditions for a short squeeze.
Betting on short squeezes in heavily shorted stocks is a time-tested, profitable strategy for speculators. Most income investors, however, are better off doing one of two things.
First, if the underlying company still appears to be healthy, the wise course is just to stand pat and wait for volatility to abate. Prudent diversification and portfolio balancing–such as not averaging down–will protect against potential damage if there’s a real crackup. Odds are the stock will eventually recover while it continues to pay its dividend.
Second, if the underlying company really does appear to be having problems–based on its numbers, not fearful speculation–the question becomes just how far the weakness goes. And in many cases, it will be enough to merit selling.
But remember, the worst-case scenario for companies rarely happens. Instead, you have a stock that’s fallen out of favor with the market because investors fail to imagine the possibility of a turnaround. We used to call that value.
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