In battle over the market, the shorts are winning

When it comes to selling stocks short, it may be time to join the crowd.

Stocks with high levels of short interest compared to total shares outstanding actually had been a leader, outperforming all other categories in 2013.

That trend continued into the first quarter of 2014, but has reversed of late.

In fact, highly shorted stocks have taken a nose-dive over the past three weeks. A basket of such companies compiled by Bespoke Investment Group is off more than 9 percent for the year after having been positive as recently as Sept. 18, the firm said in a research note. That's good news for short sellers, but bad for those betting that the shorts are wrong.

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By comparison, a basket of the least-shorted stocks is up 3.21 percent this year, according to Bespoke.

Both groups have underperformed the S&P 500, which is up about 4.6 percent year to date after slumping 3.4 percent over the past month.

A quick look at the most- and least-shorted names on the market index:

Most-shorted stocks

Short Interest
Game Stop GME 29.50%
Cablevision CVC 24.90%
ADT ADT 20.60%
Transocean RIG 19.70%
VeriSign VRSN 16.00%

Least-shorted stocks

Short Interest
Philip Morris PM 0.50%
Mondelez MDLZ 0.50%
Wells Fargo WFC 0.50%
Loews L 0.40%

The change in tenor between the most- and least-shorted cohorts reflects the market mood.

In times when risk-taking is high, investors usually will look for names where short interest is peaking and holders of those names will soon have to cover their positions. Herd mentality also is considered a pretty good contrarian market indicator, thus the popularity of highly shorted names.

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With market fear rising—the CBOE Volatility Index is up nearly 35 percent over the past month—investors are more prone toward finding safer names.

"When stocks with high levels of short interest are outperforming the rest of the market, it is a sign of investors more willing to take risk," Bespoke said. "Conversely, when the most shorted stocks are falling, it indicates that investors are becoming more cautious. Based simply on the performance of the most and least shorted stocks, investors are clearly less willing to mess around with riskier stocks."