There’s one huge risk in investing on the short side of a heavily-shorted stock. If short sellers are forced to cover their positions by buying back borrowed shares, then they unwittingly help spur a buying frenzy, pushing a stock up quickly. With the market steadily rebounding, that’s precisely what’s been happening, as the shorts’ favorite targets are some of the biggest gainers of 2012.

#-ad_banner-#Paradoxically, that makes this a great time initiate a fresh short position in these very same stocks. Short sellers already pointed the way to problematic business models, and at higher prices than when they were initially targeted, they could easily be even more overvalued now.

Short sellers are likely to retarget these names when they are done licking their bloody paws, but you have a chance to go short in these stocks before them.

Even if you don’t tend to be a short seller, the short squeeze should at least compel you to take profits if you are hold these stocks in a long position. They’ve been pushed up by exogenous factors and are likely to fall back once the current rally peters out.

The stocks below have all risen at least 30% in just the first seven weeks of 2011…

 
Unwarranted rising confidence in BofA
The sharp rebound in Bank of America’s (NYSE: BAC) stock has caught short-sellers off guard. They were right in targeting a troubled business that is still back-peddling in the wake of past misdeeds, but the shorts fell victim to generally improving sentiment toward banks. Analysts who follow the bank say the rally is overdone and shares are due to pull back.

Shares of BofA have risen from $5 in mid-December to a recent $8, but analysts at Sterne Agee say shares are worth just $6 on a fundamental basis. Their bearish take stems from a “weak profitability outlook and regulatory uncertainty given the outsized off-balance sheet liabilities.”

Mexico’s fortunes are rising, but don’t be fooled…
Mexico-based cement maker Cemex (NYSE: CX) has staged a remarkable rebound, rising from under $3 in September to a recent $8. Short-sellers have been fixated on the company’s eye-popping debt load, and their short-covering has helped fuel the stock’s rise. To be sure, the company’s balance sheet and income statement look a bit better now than they did a few quarters ago, thanks to asset sales and a modest uptick in demand. As a result, Cemex is no longer in breach of financial covenants.

Nevertheless, Cemex still carries $18 billion in debt and can ill afford a renewed slump in global economic activity. (The company has operations in Mexico, the United States and Europe). Now trading at more than 10 times trailing EBITDA, shares seem to have overshot the mark and look ripe for a pullback. These kinds of businesses often trade for closer to six or seven times EBITDA. [I recently wrote about the rising fortunes of the Mexican economy in light of China’s challenges, and there are some stocks worth looking into if you want to profit from this trend. Go here to read my original take.]

The housing rally is overdone
I’ve recently been noting the strong (and likely overdone) rally in housing stocks, suggesting they are ripe for a pullback.
 
PulteGroup (NYSE: PHM) may be the ripest of all. The homebuilder, which has been a favorite of short sellers, has risen more than 100% since the market turned up four months ago. Last fall, trading at a steep discount to book value, shares may have seemed like a bargain. Now trading at 1.5 times book value, they are clearly overvalued in the context of the company’s real estate holdings and other assets.

A two-faced stock indeed…
The rising market has shifted the spotlight back to fund management companies as investors start to pour money back into mutual funds. The sector’s shares have been making a nice upward move, led by Janus Capital’s (NYSE: JNS) nearly 40% gain this year. This outsized performance is likely attributable to short-covering because Janus is one the sector’s weaker players, dogged by steady continuing outflows at several of its top mutual funds.

Merrill Lynch sees Janus’ earnings dropping from $0.81 per share in 2011 to just $0.54 this year, thanks to reduced fund management fees as assets under management continue to drop. Shares have moved up from $6 in mid-December to a recent $8.75, but Merrill Lynch, with an “underperform” rating, sees shares dropping back to $7.

Solar woes will likely continue
Lastly, you’ll note an exchange-traded fund (ETF) in the table above. The Guggenheim Solar ETF (NYSE: TAN) has been heavily-shorted, but shorts had to scramble to cover after Deutsche Bank predicted last month that the solar industry has likely hit bottom. Many investors are dubious of that view, and even if the industry doesn’t head into a deeper slump, the recent rally more than reflects any early-stage rebounds to come.

Risks to Consider: If the market keeps on rising, then short sellers will keep on covering their positions, so could pay to wait for clearer signs that the recent rally has lost steam.

Action to Take –> This is one of the best opportunities for short-selling in a number of months, because short sellers have unwittingly pushed these stocks above fair value. I like to look for a stock chart that starts to move sideways, because that is a clear sign that short covering is over and the risk is lowered that further short squeezes lie ahead. Any of the stocks I mention above are good candidates for this tactic.

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