I am a creature of habit. At the beginning of each month, I comb through the thousands of stocks in Investor’s Business Daily’s database. I look for stocks that meet three criteria: an EPS rating over 80, an SMR rating of an A, and average daily trading volume of 500K or more.
The EPS rating measures how the company has grown earnings over the last three years with a higher emphasis on recent quarters. The SMR rating measures the company’s sales growth, profit margin, and return on equity. An A rating is the highest rating a company can get. As for the daily trading volume, I am looking for active stocks that also have decent option activity.
I have been doing this process for several years now and each month I usually end up with between 100 and 150 stocks that meet the criteria each month. Once I have narrowed the field down, I build a chart list in Stockcharts.com.
At the beginning of each week, I scan the charts of all of these stocks looking for anything that might stand out. It could be that the stock has formed a trend channel is close to the lower rail of an upward sloped channel. It could be that the stock found support at a long-term moving average. Essentially I am looking for anything that suggests that the stock is set for a rally.
The idea behind these first two steps in my process is to find fundamentally sound companies and then find a technical point on the chart that makes sense to enter a trade. I have combined fundamental and technical analysis with these two steps.
I generally end up with five to 10 stocks each week that got my attention for one reason or another. Now that I have narrowed the list down, I had a third step to the process by looking at a couple of sentiment indicators to see whether investors and analysts are bullish or bearish toward the stock. I look at the analysts’ ratings toward the stock and I look at the short interest ratio. As a contrarian, I want to see a certain amount of pessimism toward the stock. The idea being that the more bearish the sentiment is, the greater the chance the stock has of moving higher as bears turn to bulls.
What I Observed in Recent Weeks
I have been going through this whole process for several years now and have saved the results of the process for the past year. In the last few weeks, something stood out that caught my attention. There have been 17 stocks that got my attention through the process- nine one week and eight in the other week. Again, the reason they are on the list is they have an EPS rating over 80, an SMR rating of an A, the average daily trading volume is over 500K, and something on the chart caught my eye.
When I went through the final step in the process and added the sentiment indicators, it jumped out at me that the average short interest ratio over the last few weeks was much higher than what I am accustomed to seeing.
In order to test my observation, I took the short interest ratios from the 17 stocks in the last two weeks and got an average short interest ratio of 4.88. For comparison purposes, I looked at four other weeks – the first week of December, the first week of October, and random weeks from March and August. I chose the first week of October and the first week of December because these were just before serious periods of selling. There were a total of 26 stocks on the four lists and the average short interest ratio was 3.13 for those stocks.
While this isn’t enough data to form a complete conclusion, it certainly caused me to stop and think. The 17 stocks on the list in the last two weeks held up better than other stocks during the selloff and that is why they got my attention in the first place. Could it be that stocks with higher short interest ratios see less selling pressure during market downturns?
One of the reasons I value the short interest ratio as an indicator is because it can provide buying pressure should a stock rally. If a stock is rallying and it has a high short interest ratio, the investors that have sold the stock short may have to close their positions and when they do, it adds buying pressure to the stock. I had never really considered the opposite could be the case—that stocks with high short interest ratios would hold up better during a market selloff.
Looking at the 17 stocks from the last two weeks and looking at how they have performed since the beginning of December, I can tell you that 11 of the 17 outperformed the S&P during the month. There were only two stocks on my list that gained ground in December, but the average return was -6.32% while the S&P lost 9.18% during the month.
Again this isn’t a proven theory that should be applied as an investing strategy for bearish markets. I simply don’t have enough information to come to that conclusion at this time. However, you can bet that I will be paying attention to the data more closely in the future and may even try to do some backtesting to see if the idea holds water or not.