When trading in an environment with extended prices and significant macro risks, even value and growth investors need to be particularly cognizant of technical trends.  For months, the retail industry has been trading higher as the US consumer has provided much more strength than expected.  Whether this strength comes from strategic defaults, lower savings rates, or government stimulus initiatives, the bottom line is that retail outlets have seen growing sales and at least a temporarily healthier environment.

But this week, the retail index has fallen a bit behind the broad market action, which makes me concerned that the sector may be losing its leadership.  Tuesday was a difficult day for nearly every sector as Greek worries led to a sell-off in widely held growth names.  It was completely normal for retail to be hit especially hard because the industry has become a “high beta” or more volatile area for traders.

As stocks rebounded on Wednesday and Thursday, however, retail as a whole had very little strength.  If managers were really putting more capital back into speculative issues, one would expect retail to have been back to it’s Monday highs by the end of the day yesterday.  As it stands, early Friday, the SPDR S&P Retail (XRT) was back down nearly to the lows set at the close on Wednesday.

If retail is weakening as a sector of choice for growth managers, then there will likely be many dynamic stocks which make for good short opportunities within the sector.  Lululemon Athletica (LULU) is one that looks particularly interesting.

The yoga-inspired athletic apparel company has been growing its retail presence from what used to be primarily a Canadian chain – to a well established US presence.  The chain appeals primarily to up-scale athletic women (although the company’s men’s concepts are starting to pick up traction) with high prices that assure fat profit margins and a certain quality premium perceived by clients.

Many of the textiles incorporate seaweed which is supposed to be soothing for skin, and the company prides itself on offering much more than just apparel.  Lululemon typically employs professional trainers to serve customers, ensuring that customers pick out the perfect items for their own workout regimen, and offering training tips and guidelines along the way.  For LULU customers, the shopping experience is just as important as the products they walk out of the store with.

While the concept has been very successful and I have owned the stock for gains shortly after the IPO, LULU is now trading at a multiple that warrants concern.  Investors are expecting strong 30% plus growth for the next two years which will be easy for management to hit if the consumer really is organically stronger.  But if consumer spending is propped up by government stimulus or strategic defaults, the whole house of cards could come crashing down.

At this point it looks like the risks of a softening retail market are too big to ignore.  At the same time, the technical pattern on LULU is also very concerning.  After topping out over two weeks ago near $45, the stock has lost a good bit of value on heavy volume.  And it looks like there could be further weakness in store.

In early February as the market was dealing with the last correction, LULU bottomed at $25.75.  At the time, investors were worried that a weak consumer could crimp growth or even cause retail earnings to contract.  Once those fears were alleviated, the industry traded sharply higher – due in part to temporary effects of stimulus and mortgage defaults.

Once it becomes clearer that the consumer is not as healthy as commonly perceived, analysts will likely ratchet down their estimates – and investors could also cut back the multiples they are willing to pay for equities.  If 2012 estimates for LULU were cut from the current $1.39 to just $1.18 (only a 15% decrease) and investors paid a still robust multiple of 20, the stock price would fall more than 30% to $23.60.

Based on the price action of LULU, and the potential for estimates and multiples to shrink, I would recommend a short position with a tight stop.  Obviously, the bulls could still step back in and support the market and retail stocks particularly.  But it appears the risk of further weakness trumps the optimism we have experienced for so long.

FD: Author has a short position in Client Accounts

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Last week several homebuilder stocks rallied sharply as the market continued to advance to new recovery highs and managers shrugged off the “Goldman Risk” which had overshadowed traders for a single day.  Several nationwide developers broke out of multi-month ranges on strong volume, indicating that institutional managers were allocating a significant amount of capital to the sector.

Since most homebuilders are still operating at losses with huge inventories of homes and land, and stifling levels of debt, the move indicates that institutional investors are very optimistic about the nation’s economic recovery.  It will take a significant increase in wealth, along with a much better employment picture for the lofty prices on most homebuilders to be justified.

But just as the euphoric trading was catching the eye of momentum and breakout traders, Tuesday ushered in a new dynamic for growth and speculative issues.  The catalyst was renewed concern over a default of Greek debt, but the broad effect was a move away from risk by a large number of influential traders.  While the benchmark indices took on water, homebuilders quickly gave up gains from last week’s breakout and now look vulnerable to fall much further.

KB Home (KBH) builds single family homes, condos, and townhomes in 10 states across the US.  The stock had recently broken out above a consolidation area at $18.00 and immediately added more than 10% to top out near $20.  But the “risk off” trading on Tuesday negated the breakout and caused investors to lose nearly the entire gain from the previous week.  Speaking as a trader myself, this kind of volatility would cause me to re-think a long position even if I was confident in the company’s fundamentals.

As it stands, KBH isn’t exactly in great shape fundamentally, and significant risks are still in place.  Quarterly revenue numbers continue to decline although doing so at a decreasing rate.  Still, the company has reported major losses totaling $2.64 per share in the last year alone.  Analysts expect the company to lose “only” 89 cents per share this year which ends November 30, and then a gain of $0.65 is projected for the following year.

Even if the 2011 guestimates turn out to be accurate, the stock is still trading at nearly 30 times forward earnings – a difficult multiple to justify given the losses and risk of a stall in the economic rebound.  During the last quarter management tried to paint a pretty picture of the housing market, but reading between the lines it appears there is still significant concern:

Encouraging data in recent months suggest that a number of housing markets may be stabilizing or starting to rebound, though we do not yet see, in many respects, a sustained nationwide recovery.  While the pace is likely to be uneven in the months ahead, we currently expect housing market conditions to follow a generally positive trajectory throughout this year and into 2011. ~Jeffrey Mezger, CEO

With Europe continuing to be a significant red flag (I don’t think US investors realize how our fortunes could be closely tied to the international events) and US unemployment stubbornly high, I believe a rally in the homebuilding sector is premature.  We have already seen how quickly the homebuilders can give up gains when managers decide to reduce their risk levels.  Imagine what would happen if managers truly kept this mindset for more than just a single day.  In this case, I would expect homebuilders, retail stocks, many China plays, and a few other speculative sectors to take on water.

The ZachStocks Newsletter has a short position in another related homebuilder.  This luxury builder has recently had to write down the value of its land inventory which has a negative effect on book value.  I’m expecting a 20% decline in this stock along with similar negative action for the entire sector.  So if you are long homebuilders, it may be worth lightening exposure on today’s strength.  The temporarily higher prices may provide a decent short entry, and at the very least, investors should have an exit or hedging strategy in place to carefully manage the risk.

FD: Author does not have a position in KBH

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Shares of Solarwinds Inc. (SWI) are off sharply today after the company announced first quarter earnings.  While the headlines beat the published consensus expectations, the devil was in the details.  As I write, the stock is off close to 15% as growth assumptions are being challenged, and speculative investors are getting punished.

Despite the “alternative energy” name, Solarwinds is actually a network company which seeks to identify and solve network performance issues.  The company has a broad client base – boasting 93,000 customers at the end of the first quarter and offers a wide assortment of solutions:

• Network Monitoring
• Configuration Management
• Network Traffic Monitoring
• App & Server Monitoring
• IP Address Management
• IP SLA Monitoring
• Virtualization Monitoring
• Wireless Monitoring
• Network Mapping

I’m not a tech guy by any means, but I can tell you that investors were excited about this relatively new stock because of the broad number of services the company offers, and the potential to cross- sell these services to existing clients.  The idea is for the company to get their foot in the door by selling one service, and then quickly explain why the customer needs a full bundle of services to operate efficiently.

Up to this point, it looks like the company has been very effective in growing its revenue base.  The first quarter showed a revenue increase of 43% over the same quarter last year.  The business was nearly evenly split between license revenue and maintenance revenue.  The maintenance business is a bit more valuable to investors because this is largely recurring revenue with stability quarter after quarter.

But looking at management’s projections, it appears the growth rate is likely to contract considerably – which is a major concern for investors.  For the second quarter, management is guiding revenue of $36 to $37.8 million which is at best a 40% increase over the second quarter of 2009.  For the full year, revenue is expected to be $159-165 million.  This indicates that management is expecting a significant pickup in revenue for the third and fourth quarters in what is known as a “back end weighted” year.

Essentially, management is asking investors to take a “leap of faith” stating that revenues will be in the mid 30 million level for the first two quarters – and then the high 40 million range for the third and fourth quarter.  Unless there is a particular contract that management expects to land – and the timing is very specific, it would seem that the back-end weighted guidance is sketchy at best.

Despite the 15% drop in Tuesday trading, the stock still appears to be over-valued based on earnings expectations.  Management is guiding analysts to expect 72 to 75 cents per share this year which only represents an increase of 15%.  But at $20.50, the stock is trading at 27 times the high end of guidance.  This multiple might be reasonable for a stock in the middle of a strong growth period, but with heavy competition, disappointing growth projections, an extended and vulnerable market, and a technically broken stock chart; the risks seem to far outweigh the potential benefits of owning the stock.

Shorting SWI today may be a bit premature.  With the market likely to at least stage a rebound attempt from the sharply negative trade today, I wouldn’t be surprised to see SWI consolidate or even trade back to the $22-23 range.  But with the technical breakdown we have seen today and the potential for more selling as managers become less confident in the recovery, the stock will remain on my short list and could potentially trade back down to the IPO price of $13.

FD: Author does not have a position in SWI

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Shares of Neutral Tandem Inc. (TNDM) have been under pressure this year as the company struggles to maintain patent protection and fend off a significant competitor.  On March 30, Oppenheimer downgraded the stock to neutral after the United States Patent and Trademark Office agreed to reexamine a key patent which is been challenged by Peerless Network.

If the patent is overturned and Peerless is able to more directly compete with Neutral Tandem, the end result would likely cut into margins and pressure what has been a long history of sustained revenue and earnings growth.  Since Neutral Tandem began generating a profit in 2006, the company has grown earnings from 15 cents per share to an estimated $1.30 this year – quite an impressive feat for a period wrought with financial and business risk.

One of the reasons the company has performed so well is that management has approached the business from a fiscally conservative foundation.  The company currently has no debt and at the end of the fourth quarter boasted $161 million in cash.  As part of the fourth quarter earnings press release, the company announced a $25 million share repurchase program which, if traded correctly, could have reduced the share count significantly as the stock traded sharply lower during the first quarter.

TNDM announces earnings on May 5, before the market opens.  In addition to hearing information on the patent issue, I am curious to hear how much the company spent on repurchasing shares and how many shares they were actually able to retire.  I would love to see that the company acquired the shares at an average price between $15 and $16 although that may be a bit too aggressive.  The company did not set an expected period of time in which these shares would be repurchased, but one would think the opportunity in February and early March would allow the company to spend a large portion of the $25 million.

Last quarter, management guided 2010 revenue to be between $185 million and $200 million.  I can only assume that these levels will be decreased after the patent reconsideration, but the big question is whether the market has already priced in the disappointment.  The current earnings consensus (which should include adjustments made after the patent news was announced) still has the company earning $1.30 this year – representing 7% growth over last year.

With a stock price of $17.36, investors are only paying a bit more than 13 times forward earnings.  If you back out the roughly $4.80 per share in cash, the multiple would actually be below 10 – one of the most attractive prices investors have been able to buy TNDM at for since the stock started trading in late 2007.

Today’s market has been rewarding small-cap growth companies regardless of valuation risk.  Neutral Tandem certainly has its share of risk, but at the same time that risk appears to be fully calculated into the market price.  At this point, any unexpectedly positive announcement out of the patent office could have a significant effect on the stock.  If it turns out that TNDM has to compete more directly with Peerless, that will not likely be a huge negative for the stock because analysts already expect this to happen.

Following the announcement, TNDM shares have begun to rebound, and today’s trading puts TNDM above the 50 day average and back in line with where the stock was trading before the March 30 downgrade.  I expect the risk to be muted in the stock, and the current positive momentum could be the result of a significant rebound.  Even if the stock recoups just half of the loss from $34.56 to a low of $14.50, it would represent a rebound to near $25 – a healthy return for investors today.

So as we wait for the earnings announcement on May 5, I would recommend picking up a starter position in the stock and potentially adding more shares if the announcement is well received.  TNDM is a strong growth company with a talented management team.  Regardless of the patent issue, the company should be able to grow earnings and continue innovation, strong customer service, and maintain a healthy and growing customer base.

FD: Author does not have a position in any stocks mentioned in this article.

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Thursday was an important day for financial exchanges CME Group Inc. (CME) and IntercontinentalExchange (ICE).  The action was hot and heavy as traders bid ICE to a new high for the year and CME shares traded to levels not seen since January.  Investors were betting that regulatory reform would push more derivative volume onto their exchanges – boosting revenue and profits for years to come.

Up the street in Manhattan, the action was just as intense.  After calling bank executives “fat cats” and pinning much of the blame for the financial crisis on the leaders of financial firms (that’s a discussion for another day) Obama tried to bridge the gap, asking the industry to call off lobbying campaigns to derail the financial reform bill.

The meeting appeared to be civil…  No one threw shoes, shouted in anger, or spouted off to the media afterwards.  But the environment was relatively tense as the president attempted to sell his plan to a group his administration has painted as villains and irresponsible citizens.

Tension was also the theme in Washington as democrats and republicans struggled to come to agreements on the details of the bill.  With so many moving parts, and a sharp divide between lobby interests and public outcry against Wall Street, the bill will no doubt face challenges and multiple changes along the way.

Clearance of OTC Contracts

While changes will be made and the final outcome is still not a complete certainty, there will almost undoubtedly be provisions in the bill which require major financial institutions to clear a much broader portion of Over The Counter (OTC) contracts.  These contracts represent derivative agreements between financial institutions and historically have been out of the view of most investors.

Causing these contracts to be cleared would help to reduce the systemic risk associated with the potential for default, but introducing a third party (ICE or CME) to “guarantee” the trades between institutions.  Essentially, ICE and CME would require the institutions to put up margin for each trade and the exchange would keep that money segregated for settlement of the trade.  As the OTC contract moves against one of the parties, the exchange would require additional margin to account for the increasing risk.

So the business model for CME and ICE requires strict risk control, and an accurate understanding of the terms for each of these detailed transactions.  On the other hand, while the risk management is intensive, the clearance fees can be extremely lucrative which is why investors are sending the stocks significantly higher.

Critical Mass and Nimble Growth

If I had to choose between CME and ICE to invest in, I would have to side with IntercontinentalExchange.  The company has about 1/3 the market cap of CME but as an 8 billion dollar company, they still have enough critical mass to compete in the industry.  Remember, to guarantee the huge trades these investment bankers are engaged in, the clearance firms must have significant capital reserves.

Both companies have grown their businesses through acquisitions in the past, buying rival exchanges and purchasing the rights to design futures contracts on specific indices followed by managers.  The clearance market is now primarily a duopoly with any rival firms struggling to present the critical mass necessary to garner the required confidence.

ICE has always been known for its energy markets although the company has increased its product offering tremendously in the past decade.  The company has a strong reputation and has continued to grow its revenue base even throughout the financial crisis.  In fact, the financial crisis may very well have benefited the firm as sharply increased trading volumes as well as the need for third party clearance actually drove business.  I wouldn’t be surprised if we saw a similar environment sometime in the next 12 months…

Being a smaller firm, ICE can more easily pursue deals that would make a material impact on its bottom line.  International expansion is already underway, but ICE could certainly increase its presence in Europe, Asia, and in other evolving economies.  Expertise in agricultural products will also be a benefit as inflationary concerns along with a ballooning population will drive commodity trading.

Investors have to pay a bit more for ICE – which is currently trading at 21.5 times expected 2010 earnings.  But the strong growth, a management team that has proven its ability and desire to complete large deals, and a political environment that drives more business to the exchange should make the premium price worthwhile.

The recent breakout will likely be just the start of a strong run for both ICE and CME.  Pullbacks can likely be bought as there will no doubt be some uncertainty surrounding the finance bill.  But over the next 12 to 18 months I expect to see a robust return on this investment.

FD: Author has long positions in client accounts

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Thursday’s market action is reminding investors that risk is still an important issue to consider.  For months, the market has continued to march higher with very few pullbacks and decreasing volatility.  This kind of trade can lull investors toward complacency and make markets vulnerable to a sharp “shock to the system” when surprising news causes too many investors to hit the exits simultaneously.

One of the three most speculative (and potentially dangerous) areas appears to be investments in Chinese companies showing attractive growth.  With the nation reporting strong GDP growth and the middle-class consumer population expanding rapidly, many investors are willing to pay exorbitant prices to get a piece of the action.

Ctrip.com Intl Ltd. (CTRP) is a healthy, growing China travel company with a business model similar to Expedia.com (EXPE) or Priceline.com (PCLN). The company has seen growth accelerate coming out of the financial crisis as China travel has gotten a healthy boost.  In March, CTRP  broke out to a new high, exciting the bulls – only to be turned back as China stocks fall under pressure.

There is a specific catalyst brewing which could technically become an Achilles heel for the stock on a short-term basis.  On March 4, the company announced that they had sold 5.7 million ADRs to the public at a price of $36.00.  Goldman Sachs (GS) was the book runner on the deal and likely distributed the shares to favored clients.  The deal was well accepted to begin with, and initially investors made a double digit percentage return on the new shares.

But as the stock trades lower, CTRP is once again approaching that break even price where investors picked up the new shares.  There is nothing magical about the $36 price or any other point on the chart, but the interesting thing about markets is that they are dictated in the short-run by human emotions and cycles of fear and greed.

Investors who bought at $36 and were initially shown a strong profit, are much more likely to get discouraged and dump the shares if this price point is broken.  This is just as true for institutional investors as it is for individuals – I know – I’ve been on both sides of the desk…  So if CTRP crosses below this line, it could be a catalyst which would ignite a much more dangerous drop in the stock.

Valuation and Sentiment Add Fuel to the Fire

For quite some time now, CTRP has been trading at a valuation that some consider unsustainable.  At today’s price, investors are paying $40 for every dollar CTRP is expected to earn in 2010, and it’s difficult to have much confidence in the 30% gain projected for 2011.  Such high valuation isn’t necessarily enough reason for investors to immediately sell, but if the pattern changes and the trend becomes negative, investors will have a harder time justifying a position in a stock with a multiple of 40.

Sentiment surrounding China is also a bit of a concern.  From all that I read, it appears that investors are anxious to gain exposure to this vibrant growing economy.  But the political risks, currency issues, fiscal policy disconnects between China and the US, and the mounting evidence of a real estate bubble in China all cause concern.

This week CTRP has had two high volume negative days as the stock broke through the 50 day average and has briefly touched the $36 level.  I would suggest watching this price point carefully as the immediate danger would be for the stock to trade to its February low of $30 – and potentially much farther if broad sentiment begins to shift.

As always, manage your risk carefully.  There are many ways to structure a short play on CTRP – including using options, inverse ETFs or other methodologies to offset risk.  The danger of CTRP breaking to a new high should not be ignored, but the shifting trend appears to favor the bears on this speculative name.

FD: Author has short positions in client accounts Enjoy this article? Sign up for the ZachStocks Newsletter, Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

“Buckle your seatbelt, Dorothy, because Kansas… is going bye-bye.” ~Cypher – The Matrix

We’re in a different world now that the SEC has announced its lawsuit against Goldman.  I mentioned over the weekend that I didn’t expect the market to trade down immediately, but over the next few weeks and months we should see a dramatic change in the leadership on Wall Street – and in the premium prices investors are willing to pay for growth.

Monday’s market action was very interesting in that the blue chip indices (Dow and S&P 500) both traded higher, while more speculative indices (Nasdaq, Russell 2000, Small caps) actually lost more ground.  It looks like managers may still be willing to prop up the bull market, but they certainly want to be owning stocks they can justify from a quality basis rather than spinning a yarn about the future growth prospects.

If this “flight to quality” trend picks up speed, we could see a huge drop in small cap prices – especially the names with large multiples and optimistic but very subjective future earnings growth.  The short opportunities could be tremendous as investors deal with the compounding effect of lower earnings projections and lower price multiples.

Consider a company expected to earn $2.00 per share in 2010 and trading with a forward multiple of 30 (the stock price would fall at $60.00).  If analysts decreased their earnings projections by just 20%, and the market took 20% of the premium multiple off the price, the result would be a decline of 36% ($2.00 estimates would drop to $1.60 and the multiple would drop from 30 to 24).  For more speculative vehicles, the decline could be even more pronounced.

VMWare Reports After the Close

The cloud computing industry is one of the more speculative areas of the market with analysts expecting robust growth, and stock multiples trading at levels that would require excessive growth to justify.  VMWare Inc. (VMW) is currently trading above $55 despite the fact that the company is only expected to earn $1.19 per share in 2010 and $1.39 in 2011.  The company’s technology is tremendous…  But the price on the stock assumes that analysts are dead wrong and the company will grow earnings by a much higher rate.

As with any market or economic call, there is always a chance that an assumption will be proven false.  VMW may in fact grow by leaps and bounds over the coming year.  A technology upgrade cycle could lead to a broader customer base, and even a difficult economic period could cause more customers to use VMW’s services to cut costs and grow efficiency.

But the problem is that the stock price is already pricing these positive outcomes in.  What appears to be missing is the opportunity for competitors to eat into market share, for new technologies to make VMW obsolete (or at least a bit less competitive), for capital expenditures to eat into profit margins and disappoint short-term holders…  When stocks trade at these levels, the risk is tremendous and the chance of outsized positive returns become less likely.

VMWare reports after the close today and the stock is currently up 32% on the year.  Regardless of what the company says in the report, I expect the stock to have a muted or even negative reaction.  Think about it – If management says “everything is great and we’re expecting strong growth in 2010,” the stock has already assumed this is true…  The likelihood of a further advance is modest at best.  However, if management says “We’ve had a great quarter and our backlog is at the same level it was last quarter,” investors will likely be disappointed.  The odds seem stacked against the holder of this stock heading into the report.

Handicapping the Report

Although I have confidence that VMW will not trade significantly higher from the current level, I’m not willing to put too much risk on the table.  Earnings reports can offer a significant amount of volatility and if it takes a few days for the reality to sink in, I don’t want to be left holding a straight short position that continues to rally.  So to play for a sharp drop in the stock, I would consider implementing the following series of options trades:

• Buy the May 50 Puts for $1.00 per share
• Sell the May 60 Calls for $1.40 per share
• Buy the May 70 Calls for $0.30 per share

Putting all of these three trades on simultaneously, allows you to capture profits if VMW trades sharply lower between now and May options expiration.  The total dollar amount for this trade is actually a credit of 10 cents per share – which means you are paid to take this position.  (the credit will likely cover commission costs if you use a decent discount broker)

The risk on this trade is that VMW trades sharply higher from this point.  If VMW closes anywhere between $50 and $60 before expiration, all options will expire with no damage.  However, between $60 and $70, there is risk and the worst case scenario would be losing $10.00 per share on the trade.  The calls at $70 keep us from any further exposure.

A price of $70 is very unlikely given the high multiple and the challenges VMW has had in growing top line revenue or bottom line earnings.  But despite the unlikely nature of this loss, one still has to account for that possibility.  On the other hand, if VMW starts trading for a still aggressive 30 times 2011 expectations, the stock could quickly drop below $42.

So consider using this options strategy ahead of the earnings announcement, but as always, do your homework and understand the risks of trading any vehicle before stepping into a trade.

FD: Author does not have a position in VMW

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The SEC’s suit against Goldman Sachs on Friday brought an entirely different tone to equities markets.  In an environment where investment assets have become overly correlated, many investors have noted a “risk on – or risk off” approach to trading.  When news is positive – or even marginal – the “risk on” mantra applies and managers use available cash to load up on high-beta names.  However, if we are now entering a “risk off” period, it will not just be the investment banks which will suffer

At risk are many of the sectors which have seen the most speculative buying since the most recent January swing low.

Markets have continued to motor higher, and recently the crossing of major points of interest (11,000 on the Dow and 1200 on the S&P 500) has had a major psychological effect on short exposure.  For the most part, short-sellers have picked up stakes and gone home – leaving the market more vulnerable to a significant drop.

When there are enough short participants in a market, that can help to add support.  This is because profit taking occurs when markets fall – and shorts covering profitable positions can sometimes be the majority of buying interest in certain stocks or sectors.  With very little short interest, a significant drop in speculative sectors could go un-checked and lead to more volatility.

So due to high levels of speculation and risk – and with the next inclination likely to be a flight to safety, here are the three areas I think traders should be most interested in shorting.

Consumer Discretionary / Retail

The retail industry has logged some impressive gains since the pullback in January / February.  After hitting a low on February 5, the retail HOLDRS (RTH) made a new recovery high in just 20 days, and has continued to march steadily higher.

Individual retailers have been reporting a pickup in sales levels and with inventories largely low and overhead costs also reduced, the profitability increase has been tremendous in some cases.  For the most part, the profitability increases has been boosted by one time issues (it’s unlikely that companies will continue to cut overhead and inventories are already picking up in anticipation of stronger demand).

The same could be said about the consumer demand for goods.  Especially if you buy into the concept of strategic defaults boosting consumer spending.  Since I have written the article on strategic defaults, I have received what I would consider a bi-polar response with many outraged readers suggesting the concept is ludicrous, while the other half actually know at least one (if not more) friends or neighbors engaged in a strategic default situation.

The ability to spend more through living rent-free in one’s house (by simply not paying the mortgage) cannot continue indefinitely and when this practice is stopped, it is likely consumer spending will once again decline – especially since employment numbers have yet to show much in the way of recovery.  When consumer spending is called into question – or simply when managers start applying the “risk off” portfolio management, retail stocks could take the brunt of the selling.

Shorting the RTH vehicle is one broad way of capitalizing on this movement, but it may be more profitable to focus on some individual stocks which have experienced significant gains and could be due for a pullback.  Stocks that quickly come to mind (for more research later) include Abercrombie and Fitch (ANF), Ann Taylor (ANN) and potentially Lululemon Athletica (LULU).

Domestic China Companies

Strong economic growth in China has attracted significant foreign investment and led to strong price appreciation.  While speculative buying has supported strong price multiples, another issue has been reduced supply of available investment vehicles.  Since the Chinese government restricts the amount of financial assets available to foreigners, mutual fund managers and other institutional investors have found it difficult to secure their desired level of exposure to China.  By nature, a low supply of an asset coupled with strong demand will result in higher prices.

With current prices already reflecting strong long-term growth for the Chinese economy, it would only take some small disappointments for this sector to begin to fall.  The strong GDP reports are likely to cause the government to be more aggressive, tightening regulations on the banking sector which would reduce available capital to industry.  As these measures are enforced, the Chinese economy could continue to grow at a slower pace, but the stock prices could decline sharply to reflect the lower growth rate.

Two easy vehicles for investors to trade are the iShares MSCI Hong Kong (EWH) and the iShares FTSE/Xinhua China 25 (FXI).  The EWH includes a broader section of the Chinese economy, while the FXI has a larger financial concentration.

For a bit more volatility (and potentially larger gains) traders  could consider short positions in individual China companies:

• E-House China (EJ) – A real estate agency whose profitability is closely tied to property transactions in China’s overheated real estate market.
• Baidu Inc. (BIDU) – The well-known Google competitor running online advertising and internet search capabilities.  The stock has a strong trend but investors are paying 63 times this year’s expected earnings.
• Home Inns & Hotel Management (HMIN) – A Chinese hotel manager with a high multiple and declining revenue growth.  The hotel industry is closely tied to a vibrant economy and any hiccup could send the stock sharply lower.

US Regional Banks

During the last financial crisis, many of the largest banking institutions were deemed “too big to fail” and were subsequently bailed out or backstopped by the US government.  While it is certainly not fair, the majority of US regional banks are decidedly NOT too big to fail and face significant risks in today’s environment.

A rising stock market and improving confidence has led many investors to overlook balance sheets with excessive leverage, and the impending danger of write-downs.  Commercial mortgages still comprise a major risk to regional banks and many of these loan portfolios are still being carried at valuations which imply economic health and little risk of default.

If the Goldman news causes a new “risk off” dynamic with lower amounts of liquidity and a focus on what could go wrong instead of only what could go right, the multiple on many of these smaller and more vulnerable banks could decline sharply.

There are two primary ETFs which were designed to track the regional banks – the iShares DJ US Regional Banks (IAT) is comprised of some of the largest regional banks like US Bancorp (USB) and BB&T Corporation (BBT).  While these banks may be vulnerable, they may also still fit into the “too big to fail” bucket and be propped up by the government in some shape or fashion.

For this reason, I’m more interested in the SPDR KBW Regional Bank (KRE).  The ETF is made up of many smaller banks and even its largest holdings only represent a small portion of the total fund.  Shorting this vehicle will give traders more exposure to the general factors that affect the small traditional US bank, and looking through the top 25 holdings for this ETF (which can be found on Morningstar.com) could yield some individual picks that are even more powerful.

Timing is Everything

Timing will be key when laying out shorts in the post Goldman lawsuit period.  My expectation is for bulls to step in early this week and prop up markets.  After such a stunning run for the last 6 weeks (and for the last 12 months for that matter), it is hard to imagine the market rolling over and heading directly south without at least a week or two of wrestling.

Using reflex rallies to lay out shorts may help to cut risk.  At the same time, small positions could be initiated right away so that if the bearish sentiment takes hold immediately, at least we have some exposure taking advantage of the new trend.

For long positions in these three sectors, I would urge caution.  True investors may want to hold these positions long-term for better tax treatments and for fundamental reasons.  If this is the case, it may make sense to sell calls against individual stocks to create some income and reduce the risk, or potentially buy inverse ETFs which can generate gains while the market falls.  This could help offset traditional exposure and lead to better long-term profitability for your portfolio.

The ZachStocks Newsletter will likely begin adding short positions later this week or early next week.  At this point we are waiting to get a better feel for the market reaction, but should be able to use a reflex rally to step into some profitable shorts at appropriate risk / reward ratios.  The important thing for traders to do at this point is to continue building a watch list of appropriate short candidates so that when the decline begins in earnest, we will have a robust list of short candidates.

FD: Author does not have a position in any stocks mentioned in this article.

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Financial markets are facing extreme selling today after Goldman Sachs (GS) was charged with fraud by the SEC for marketing debt products which were essentially designed to fail.  According to the accusation, John Paulson assisted Goldman in creating Collateralized Debt Obligations (CDO) which allowed investors to capture positive cash flow by essentially “insuring” mortgage securities.  Paulson who took the other side of the trade ended up getting paid huge sums when the mortgage market eventually fell apart.

The SEC charge brings up an interesting philosophical debate.  How much liability should Goldman (or for that matter Paulson) have for creating investment products that buyers were clamoring to own – even if it was clear that the end result would be major losses for clients of Goldman.

Keep in mind the years leading up to 2007.  Real estate prices continued to climb and optimism reigned supreme.  Middle class, lower class, and even upper class consumers were all but assured that the way to build permanent, sustainable wealth was to own real estate – a LOT of real estate.  Since land has a fixed supply (how many times did we hear the wisecrack “they’re not making any MORE of it”?) investors expected the price of homes, land, condos and office properties to continue to rise ad-infinitum.

Leverage was strongly encouraged because when prices do nothing but rise, leverage works in the buyers favor.  So Wall Street was all-too-happy to create opportunities for non-creditworthy buyers to get in the home of their dreams.  It all made financial sense because if the buyer eventually defaulted, the value of the property would have risen to more than make up for the loss on the loan.  And typically, owners would simply refinance, borrowing more on the value of the property – and use the money for paying the loan or other discretionary purchases

Owning a home could actually become a self-funding venture.

Caveat Emtor?

So during this manic time period, investor appetite for mortgages naturally increased.  Think about it…  When buying mortgage securities, you were essentially loaning money to purchase properties that continued to appreciate in value.  The collateral was becoming more valuable, meaning that every day your loan became more secure.

In this environment, it’s hard to understand why Goldman wouldn’t offer mortgage products to investors who were begging for more supply.  If you’ve read John Paulson’s book The Greatest Trade Ever (a great read I might add) you would see just how strong the demand was for these securities and how the momentum fed on itself.

I guess my main question is – was Goldman really wrong to sell ill-fated mortgage securities to willing and experienced professionals? I know there is more to the story than this, but the bottom line is that these CDOs weren’t being sold to individual investors who knew nothing about the market.  They were being sold to pension funds, endowments, hedge funds – to institutions managed by professionals who should have researched what they were buying.

Part of the SEC’s accusation centers around the fact that Paulson & Co. helped to pick out the individual mortgages or baskets that went into the CDO securities.  This is certainly something that should have been disclosed to buyers – if the seller has access to non-public information that the buyer cannot uncover, then the playing field is tilted.

But what worries me is the moral hazard that is emerging in the financial markets.  More and more, it seems that we expect gains to be privatized (meaning if companies MAKE money, they get to keep it), but losses are socialized (the government steps in to make losers whole).

What ever happened to a fair market where willing buyers and willing sellers met to exchange goods (be they industrial, agricultural or financial goods)?  If I make a trade and lose money, the responsibility is mine.  My job is to cut my losses, learn a lesson from the mistake, and move on to bigger and better trades.  The same should be true of all market participants, and if you or I buy products that we don’t understand, then we shouldn’t be involved in that market in the first place!

But I digress…

Where To From Here

My suspicion is that the market won’t completely fall apart at this juncture in the game.  The bulls have been entirely too strong and we have been conditioned to “buy the dips” (even though there have been precious few dips to buy recently).  Investors with any capital on the sidelines have largely been kicking themselves for not participating and promising to put their capital to work the next time we get a correction.

So this buying pressure brought on by classical conditioning will likely stabilize the market in the short-term.  So I wouldn’t bet the farm on a major short position Monday morning at the open.

However… I DO think that over the next two months we will have a significant negative move in the market and give up a good portion of recent gains in speculative positions.  Even though a lawsuit against Goldman has very little to do with most industrial, technical, medical or retail stocks, the political risk introduced into the market could have the effect of decreasing the multiple investors are willing to pay on stocks across the board.

Currently, the majority of short positions have been closed as traders have been punished for any bearish bets.  Short sellers usually help to stabilize falling markets because they represent pent up buying pressure as they buy to cover their positions and collect their profits.  With these participants largely out of the market, the decline could turn out to be much more severe.

Prices are currently at levels that imply a full, robust recovery, so any change in this expectation will cause “long and leveraged” managers to re-think their positions.  So after an initial buying period, don’t be surprised to see the market head south in a hurry.

I’ll be using the next week to brush up on my short watch list and look for names that have the most risk, the highest multiples, and investors with the strongest confidence.  While many of these names will be tough to short (due to the strong price momentum), watching the charts carefully for good entry points, and managing risk with stop orders could turn out to be a very profitable endeavor.  I have felt like the first quarter didn’t offer too many opportunities for large profits, but the climate today makes me excited about the new opportunity for traders willing to play both the long and the short side of the market.

FD: Author does not have a position in GS

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Wednesday, many of the for-profit educational companies got a lift after Credit Suisse (CS) upgraded Devry Inc. (DV) and ITT Educational Services (ESI). The report basically stated that regulation changes for the industry are not likely to be as severe as originally expected and investors can now purchase these companies with better visibility for future profits.

The Department of Education recently submitted “Gainful Employment” proposed language to the Office of Management and Budget to estimate the costs of the new proposed language.  Credit Suisse expects this language to be submitted to the public by mid-May or at the latest June 1.  From that point there would be a comment period followed by enforceable regulation likely to start November 1.

At question is the issue of federal student loans to pupils enrolled in for-profit institutions as they pursue undergrad or graduate degrees.  Since most student loan programs are federally insured, the government has a vested interest in making sure these education programs are up to standard quality, and that graduates are able to perform well in the workforce (and therefore pay off their student loans.)

There have been widely circulated reports (including a cover story in Barron’s Magazine titled Leveraging Up to Learn) which claim that students who graduate from for-profit institutions are less likely to find gainful employment and more likely to default on their loans.  The negative press has caused investors to think twice before committing capital to for-profit schools and by extension, what used to be lofty multiples on these growth stocks are now actually attractive compared to expected earnings.

If Credit Suisse’s analysis is correct, and these institutions end up facing less regulatory pressure, we could quickly see multiples on stocks increase as investors focus on the growth aspect rather than the risk dynamics.  Since risk seems to be ignored in nearly every other sector right now, I don’t have a hard time believing that traders could quickly jump on the educational bandwagon.

• Devry Inc. – Over the last four quarters, Devry has seen its revenue increase between 28% and 43% for each of the quarterly reports.  Earnings per share has been even more impressive with growth of 40% to 69% using year-over-year comparisons.The stock is trading at less than 20 times earnings even though analysts expect 53% growth in fiscal 2010 (the company’s fiscal year ends June 30) and another 24% in 2011.  A strong balance sheet with no debt should help to inspire confidence, and the stock just broke out of a consolidation on strong volume.  Buying near $70 could turn out to be a very attractive trade over the next three to six months.
• ITT Technical Institute – The company has similar growth characteristics to DV, but a bit more of a leveraged balance sheet.  The most recent report showed a debt to equity ratio of 96% which is manageable as long as cash flow continues to increase.ESI is trading at a much cheaper multiple of 11 times 2010 estimates which could either imply a better value proposition, or less growth potential than DV.  Tuesday’s trade broke the stock out of a relatively healthy looking consolidation, but in early trading Wednesday the stock was giving back much of the gains.  I would recommend keeping ESI on the watch list and potentially buying once the stock rallies above $118 again.

There are plenty of other education companies in the sector to look at – a few of which may actually offer better trading opportunities.  I’m lining up one of these trades for readers of the free ZachStocks Newsletter so make sure you’re subscribed and looking for the trade in the morning.  As always, manage risk carefully and know where your stops will be.  The industry is likely to trade much higher, but if my analysis is premature or even dead wrong, you want to have an exit strategy if the positions head south.

FD: Author does not have a position in any stocks mentioned in this article.

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