The strategy was relatively simple: short sell momentum stocks as they begin to show signs of weakness. In 2011, we saw a changing of the guard. Several prominent momentum names — even market leaders — had various weaknesses exposed and exploited by short sellers. Keep in mind that these are household names — many of which were considered can’t-lose investments since the 2009 bull rally began.

Every single one of these high-flying stocks had a distinct breaking point. Once the investing public began to turn against them, the inflated valuations would no longer stand up to scrutiny. What resulted was a death spiral that mutilated every buy-and-hope investor in the market.

The momentum meltdown could very well continue into 2012. Several market leaders, including Apple Inc. (NASDAQ:AAPL) have showed signs of weakness lately. And while it’s not a short opportunity just yet, we could continue to see additional investor favorites bite the dust during the new year.

To help you spot these opportunities, let’s review the signals that set up some of this year’s biggest shorts:

Netflix Inc. (NASDAQ:NFLX): Netflix was the most prominent stock to fall from grace this year by far. Up until June, this was the best performing stock in the U.S. since the markets bottomed out in March 2009. Sadly, due to numerous subscriber pricing miscues and what later turned out to be complete managerial incompetency, the company that bankrupted Blockbuster and held a virtual monopoly on paid movie and television streaming completely fell apart.

From a high of almost $305 per share, the first sign that something was very wrong came in late July when the long-term uptrend was broken on the weekly chart. Market weakness exacerbated the plunge, helping shares lose more than 75% of their value since the summer highs:

Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR): Coffee stocks — a group that includes Green Mountain and several sympathy plays — were one of the hottest investments on Wall Street earlier this year. For the first half of 2011, shares of GMCR soared from $32 to a high of $115 by September.

But outrageous growth projections eventually got the better of GMCR, sending shares briefly below $40 by the start of November. As you can see from the chart below, GMCR first broke below its accelerating trendline (dotted blue line) in September. For more conservative traders, another short opportunity presented itself last month when shares violated the longer-term trendline:

Sodastream International Ltd. (NASDAQ:SODA): Sodastream is an intriguing company, which is one of the main reasons the stock became so popular in 2011. As consumers began touting the benefits of the company’s at-home carbonation systems, the stock began to take off. Unfortunately, it has yet to recover from the August correction. Shares remain more than 50% off their highs:

As 2012 approaches, keep an eye on potential momentum breakdowns that mirror these patterns. They could end up being some of the best plays of the year…

Sincerely,

Greg Guenthner
for The Penny Sleuth

Momentum Meltdown: The Best Trade of 2011 was originally featured in the Penny Sleuth.

In any market climate, short selling can be a great way to hedge losses in your portfolio. Let me show you how…

If you think a particular stock is going to fall, one way to make money as it falls is to short it. Simply put, to short a stock you “borrow” shares and then sell those shares at market value and pocket the proceeds. When the stock falls below the share price you sold at, you can buy back the borrowed shares at the lower price to give back to the owner (known as covering), pocketing the difference.

To short you will need to open a margin account with your broker.  Your broker will arrange the delivery of the borrowed shares.  There is often a ready supply of shares to be borrowed, usually owned by pension funds, mutual funds, or individual investors.

Finding the Right Stock

Finding the right stock to short can be a little bit tricky, but there are many aspects of a stock you can look at when finding the right stock to bet against. Generally, you want to make sure that the stock you are looking to short has high liquidity, which means that there are a decent number of shares being traded.

Some good signs of a short selling opportunity are when a company misses its quarterly earning estimates, its fundamentals are dwindling, sector trends are declining, or the stock is seeing high insider selling.

Too Good to Be True?

It all seems simple enough… you sell high, buy low, and then keep the difference.  But there are some risks when short selling that you need to be aware of.

As I mentioned earlier, in order to start shorting, you will need to open a margin account with your broker. There may be additional margin costs involved when you are shorting the market and you will have to pay out any dividends that were paid during the time frame you were borrowing the shares.

In the case of “hard to borrow stocks,” you need to also be mindful of the trading activities of the owner of the shares you are borrowing.   If he decides to sell his shares before you have covered, you will have to return the shares to him by either purchasing at market value or borrowing them from somewhere else. This is known as a forced buy-in.  Your broker will have a list of these companies.

Most importantly, unlike long investing where you can only lose what you invest, with short selling losses are hypothetically limitless.  If a stock you are shorting goes up, you will have to buy shares at the current price to cover your short, resulting in a loss. A “short squeeze” can cause a rising stock with short interest to rise even higher when fellow shorters are also attempting to cover their short.

High Risk, High Reward

Most investors won’t short stocks because they don’t know how or because they are scared.  While short selling does have high risk, you can also reap high rewards— especially in a down market. Picking the right stock to short can easily help you book fast gains. Just remember not to chase your short; set a price you will buy shares back at, and stick to it.

Have more investment questions? Please feel free to send any questions you have about investing directly to me at editor@pennysleuth.com.

Sincerely,

Jessica Comitto
Associate Editor, Penny Sleuth

How You Can Profit as Stock Prices Fall was originally featured in the Penny Sleuth.

Here’s why the only way to make money in this market is to turn conventional investing strategy on its head…

As cool weather descends upon the Northeast U.S., risk appetites start to wane. Last week, traders and investors finally sobered up. Are they second-guessing whether government spending can actually kick-start a sustainable recovery? Both stocks and corporate bonds sold off sharply.

The big questions of the moment: What kind of economic environment do we face? And more important, what’s already priced into the stock market? Here’s my view on these themes: As we see with “cash for clunkers,” government stimuli simply steal demand from the future.

But more importantly — because this is not yet a mainstream view — the real job creators in the U.S. economy, small businesses, will not expand hiring as expected. There are many reasons for subdued hiring plans; an emerging reason to avoid expansion and hiring will be heightened expectations that tax rates will soar in the future to pay for out-of-control government spending.

So I expect over the next several months, mainstream pundits and forecasters will start worrying about tepid hiring, even as the pace of job losses slows. As we “lap” the 2009 corporate cost cutting by early 2010, and top lines fail to rebound, earnings estimates will have to come back down. I’m amazed at how many sell-side analysts are modeling V-shaped recoveries in 2010 earnings. Most stock prices are disconnected from reality.

Another big question is how will policymakers respond to a sluggish-to-nonexistent rebound in hiring? The economically illiterate, and those with preconceived “big government” agendas, will use any crisis as an excuse to expand government. You’ll be ahead of the game if you realize — as many in the media and academia clearly do not — that the government has no resources. It’ll take money out of one of your pockets, skim some off for its cronies, and expect you to be grateful when they put some of it — debased by the Fed’s inflation, of course — back into your other pocket.

The labor market is dealing with a structural imbalance fueled by government-sponsored housing and credit bubbles. Many will call for the government to “solve” this labor market problem, which will cause a new type of market dislocation. By early 2010, some will push for the federal government to start hiring the chronically unemployed in “New Deal” type of programs.

Where you stand on this question will determine your expectations for the future performance of most stocks (ignoring special situations). I certainly don’t enjoy having such a bearish outlook on the economy, but it’s the conclusion I reach after weighing all the evidence about the real economy; the credit markets; and policymakers’ damaging, distorting influence.

Some pundits point to corporate mergers and acquisitions as reasons to be bullish, ignoring that fact that most deals occur closer to the peak of markets, and most deals destroy shareholder value, because the buyer overpays. The 2000 AOL-Time Warner merger is a case in point.

Recently announced deals in pursuit of tech service companies are not a sign of strength; they’re defensive moves to counteract declining hardware sales and profit margins. Cisco is constantly adding to its extensive list of acquired technology companies partly to divert the Street’s attention away from the poor growth prospects and rising competition in its core businesses. Dell’s and Xerox’s recently announced acquisitions are defensive because the computer hardware business stinks.

Corporate CFOs and Treasurers are happy about the recent bull market in risk. They know much more about their prospects than outside investors, so their balance sheet management is telling. In a word, the approach toward capital structure is “defensive.”

Heavily indebted companies are flooding the market with follow-on stock offerings to pay down debts. They’re also taking advantage of the Pollyannaish mood of the corporate bond market to issue risky bonds at attractive rates, as default risk seems to be a distant memory of bond buyers. Many corporate bond investors have taken the Fed’s bait to reach for yield, regardless of credit risk.

This isn’t the “buyer’s market” that most of Wall Street would have you believe we’re in.

That doesn’t mean that there isn’t a colossal amount of money to be had in stocks right now – if you’re betting against them. That’s exactly what I’m advising my Strategic Short Report readers to do on a daily basis.

It’s time to turn around your investment analysis and look for companies that are poised to crash, not the ones that could rally in the coming months. Once investor sentiment turns back around, you wont want to be on the long side of most stocks.

Regards,
Dan Amoss

October 8, 2009

The Cold Hard Truth About Economic Recovery was originally featured in the Penny Sleuth.

At All About Trends, the action in leading stocks — stocks that have delivered solid returns during this rally — is what we use to gauge the health of the market. That’s because in order for the market to continue to advance, the leaders must lead the market higher. And lately, those stocks have struggled — just look at AMZN, SNDA, NFLX, BWLD, JOSB.

That said, it’s not surprising to us to see what’s happening in the NASDAQ. And since the NASDAQ often leads the market, we expect to see topping patterns in the Dow and S&P very soon.

As you can see above, the NASDAQ has formed a Change In Trend pattern — from up to down.

Typically, there are three short sell set-ups that provide the best opportunity for low-risk gains. They are:

• Double Tops
• 1st Thrust Down
• Pullback Off Low’s

The above chart of the NASDAQ sports all three. The first clue that a change in trend is near is the formation of a double top (the red lines). Then, we have the first thrust down, which you can see from the second top down to the start of the pink line — the stocks that have led the NASDAQ higher are also now showing a first thrust down which explains the selling in AMZN, SNDA, NFLX, BWLD, JOSB.

And finally, you have a Pullback Off Lows pattern (the pink line). When a stock or an index completes its First Thrust Down, it will eventually find support and attempt to rally. This rally attempt is called the Pullback Off Lows pattern.

All of these set-ups are tradable on the short side.

Let’s start with SNDA first.  SNDA formed a solid Double Top pattern. This is what it looked like before it triggered a short-sell trade:

When it broke its pink uptrend line, it began its First Thrust Down.

JOSB is another example of a stock that is in the First Thrust Down phase.

As you can see, JOSB formed a double top as shown by the red line. The blue box is the first thrust down which is often a steep, quick sell-off — in this case JOSB has lost 14% in just two days.

These First Thrust Down moves start when a stock tops and then breaks its upward trendline. The place to take the trade is at the trend line break.

Finally, after a stock completes its First Thrust Down, it will eventually attempt to rally back. When they do that, they will form the third short-sell pattern we look for called the Pullback Off Lows pattern. LOPE formed this pattern back in March and here’s what it looked like as it triggered:

This pattern is the exact opposite of the Pullback Off Highs pattern we’ve discussed in the recent past. It’s also usually the start of many trades we can do on the same stock. As you can see here, when a stock reverses course and starts making lower highs and lower lows, each rally attempt is a new short-sell opportunity.

Sincerely,
David Grandey
All About Trends

May 11, 2009

Three Ways to Short Stocks was originally featured in the Penny Sleuth.

“Give me control of a nation’s money and I care not who makes her laws.”

— Mayer Amschel Rothschild

Let’s observe a moment of silence to mourn the slow demise of capitalism in the U.S.

Our government is now overtly manipulating the stock market. We have “crossed the Rubicon.” We can no longer pretend to be a free market capitalist country while also maintaining confidence in the U.S. dollar as reserve currency. After this panic subsides, the investing environment will be very different.

Make no mistake about it: The last two weeks will go down as one of the most pivotal periods in financial history. The financial landscape has changed so dramatically that few have had a chance to catch their breath. I’ve spent the entire last week reading and thinking through the free market’s ultimate response to this unprecedented, rapidly changing situation.

Last week, the SEC announced a temporary ban on new short sales in 799 specific financial stocks. We’ve talked about short selling here at Penny Sleuth in the past. It’s one of the most important weapons in an investor’s cache. It allows the market to react to foul play and sloppy corporate leadership. This is an even more important tool to use against poorly run small caps. That’s why this ban is so significant.

Before I go on, let’s first clear something up: This new ban doesn’t mean that existing short positions must be covered. But many are clearly closing short positions to limit risk anyway. The SEC might well have sparked a panic liquidation in other areas of the market, as hedge fund managers liquidate long positions to offset losses on short positions. As I write, the market is well off its highs just one hour into Friday’s trading day. Odds are good that the SEC will realize that its decision only sucked a huge amount of liquidity out of the stock market and reverse its decision to something more sensible, like reinstating the uptick rule.

While on the subject of the SEC’s new short selling rule, allow me to state the obvious: Short sellers did not bring down the investment banks. Once the investment bank executives made the decision to operate their balance sheets like Long-Term Capital Management on steroids, the writing was on the wall. They relied far too much on “quant” models, rather than good old-fashioned common sense.

Rather than target the individuals who had been warning about this situation for years, why doesn’t the SEC investigate the proprietary trades of the banks’ trading desks? I’d expect it would find evidence that the investment banks were short selling each other’s stocks at the same time that they were cutting each other’s lines of credit. In the autopsy of Lehman Brothers’ balance sheet, we have discovered that Lehman management wildly overvalued its toxic assets. Why wasn’t this taken as evidence that the lack of transparency at investment banks is at the root of last week’s crisis?

The SEC’s decision to ban short sales of financial stocks is throwing sand into the markets’ gears. Like most government action, it pays lip service to consequences. Convertible bond traders use short selling to hedge equity risk. After this ban, the price of convertible bonds will probably fall.

Hedge fund managers use short sales to offset the risk in holding long positions. After this ban, fund managers will have to use other means to cut risk, which include selling off huge chunks of their long positions.

Finally, at market bottoms, short sellers provide demand for stocks when they buy to close out short positions. Without this buying pressure, the market could possibly go “no bid” at crucial periods when long investors want to get out at any price.

The SEC would really benefit the market if it cleaned up the system of trade clearing. “Naked short selling” occurs when brokers take orders for short sales and don’t locate the shares to borrow. If a broker cannot locate them, then it shouldn’t tell the short seller that it is able to execute the order. Since the broker doesn’t want to lose the short seller’s business, it probably executes short sales of “hard to borrow” stocks anyway and hopes it can locate the shares in time for settlement.

“Quant funds” — the ones that use computers to trade millions of shares every minute — are lucrative brokerage clients. These funds are most likely to be the ones unknowingly requesting “naked” short sales. The orders come in so fast that it’s hard for the broker to say no, we cannot locate those shares to borrow.

In my view, the SEC can solve the problem of naked short selling with better enforcement of existing rules. Brokers should not be allowed to execute orders to short shares that they have little chance of borrowing. It’s vital that we restore liquidity to our stock market, rather than implement poorly thought-out decisions made overnight.

Best regards,
Dan Amoss, CFA
September 22, 2008

The Short-Selling Ban was originally featured in the Penny Sleuth.