If I make a custom image, say a liveUSB image, it would be nice to recompress image.squashfs sometimes. If you allowed XZ for example one could put the live system in a smaller device. So please configure squashfs-tools>=4.1 with lzma flag for the live environment.
USE=lzma in version >4.1 should give you XZ support. Maybe the USE flag ought to be renamed - it's there for historical reasons I guess.
Next time around, please use the package's metadata.xml to show you whom to assign bugs to.
In 4.1 upstream still called XZ support "lzma", and this was improperly propagated to the 4.2 ebuild, it seems. I am working on changing IUSE=lzma to IUSE=xz now.
--- ChangeLog 2012-02-08 19:11:32.000000000 +0100 +++ ChangeLog.new 2012-02-08 19:23:57.000000000 +0100 @@ -2,6 +2,10 @@ # Copyright 1999-2012 Gentoo Foundation; Distributed under the GPL v2 # $Header: /var/cvsroot/gentoo-x86/sys-fs/squashfs-tools/ChangeLog,v 1.78 2012/02/08 18:11:32 jer Exp $ + 08 Feb 2012; Jeroen Roovers <jer@gentoo.org> squashfs-tools-4.2.ebuild, + metadata.xml: + Change USE=lzma to USE=xz now that upstream calls it that way (bug #400939). + 08 Feb 2012; Jeroen Roovers <jer@gentoo.org> squashfs-tools-4.2.ebuild: Stable for HPPA (bug #400937).