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Canada’s market rally is no ‘dash for trash’

Informative analysis from U.S.-based Bespoke Investment Group highlighted a "dash for trash" in equities south of the border, with the most shorted stocks outperforming by the widest amount. In the Canadian market, there has been no clear relationship between most-shorted stocks and recent performance during the rally but, in the end, it comes down to how we define "trash."

In a Feb. 19 research report, Bespoke Investment Group noted " a clear correlation between levels of short interest and performance. Stocks with the lowest levels of short interest are up an average of 4.7 per cent. … Stocks in the decile with the most heavily shorted stocks are up the most of any decile with an average gain of 7.3 per cent."

(Outperformance could be explained by the high amount of shorts representing excess pessimism, with the stocks then perceived by the market as oversold; as well, people who shorted this "trash" are running to cover their positions. Or it could as simple as the most-shorted U.S. stocks were in energy and mining – then oil and copper rallied.)

I used the same methodology to look at the S&P/TSX composite, arranging all index stocks into deciles according to the largest short positions as a percentage of total stock float. I expected to see the most-shorted stocks generating the best performance since the 2016 market low on Jan. 20. It didn't work out that way.

The accompanying chart shows the average and median returns for each decile of shorted stocks. For example, the bars on the far left of the chart show that stocks in "Decile 1" – Canadian companies with the largest short positions – generated an average return of 3.9 per cent between Jan. 20 and Friday's market close. The median return for the group was 1.3 per cent.

Unlike the U.S. market, the most-shorted stocks in Canada were the worst-performing stocks since the market bottom, not the best. The top performing decile in the TSX was the seventh with an average return of 18.7 per cent – a group with a low short interest relative to the rest of the benchmark.

Three companies in Decile 7 provided the bulk of the upside – Bonavista Energy Corp.'s 68-per-cent return, Silver Wheaton Corp.'s 41-per-cent appreciation and Barrick Gold's 46-per-cent return from the January market low. Eldorado Gold and Agnico Eagle Mines also helped boost the numbers.

In each case, the reasonably small short positions are less a function of objectively strong balance sheets and outlooks, and more because there are weaker stocks in the energy and precious metals sectors that make for better shorting opportunities. In other words, these stocks are resilient and benefiting from being "relatively" strong in an index chock full of beleaguered commodity stocks.

For investors, these patterns support an emphasis on higher quality stocks with strong balance sheets. It makes little sense to own bankruptcy risk in any sector if the higher quality names are generating stronger performance during market recoveries.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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