Categorized | Featured, Markets, Short Ideas

Three Industries for Building Short Positions

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.

Newsletter AdMarkets 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.

Retail Holders (RTH)

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.

iShares FTSE/Xinhua China 25 (FXI)

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.

SPDR KBW Regional Bank (KRE)

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.

Other Articles of Interest
Why The Market Won’t Trade Straight Down From Here
Rampant Speculation in Restaurant Industry
Calculated Risk: Weekly Summary & Look Ahead
Prag Cap: China Learning Keynesianism the Hard Way

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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Three Industries for Building Short Positions

13 Comments For This Post

  1. captainccs Says:

    Shorting is a dangerous game, the reward is limited while the risk is unlimited. Buying puts is a safer way of doing it.

    As for shorting RTH, it is just a few points short of the 2007 all time high. You don’t short on the way up, wait until the trends breaks and reverses. But there is more, a lot of the second rate retailers have gone broke, Circuit City, Linen ‘n Things, The Sharper Image, etc. That means more market share for the survivors. And the survivors have gotten lean and mean, cutting costs, paring inventory, closing underperforming locations, renegotiating rents, etc. I’d be very careful about shorting retail at this point.

  2. Zachary Scheidt Says:

    Captainccs – You’re going to have to excuse me for the following rant… Seriously, I apologize – it’s not directed at you, but at the continual assumption that “shorting has unlimited risk” and casually assuming that this is better than the “limited risk” of buying into an extended market…

    What kind of idiot would short a stock and continue to hold it for the “unlimited” risk you talk about? If the position moves against you, then CLOSE IT OUT! Risk control is the most important part of investing whether you are long only, long short, a daytrader, swingtrader, position trader, or horse trader! Of COURSE the mathematics say that risk is unlimited, but the practical application of shorting a stock or ETF or market would require you to manage that risk.

    Too many people use this overstated technically true but practically obsolete statement to simply excuse themselves from having to think about BOTH sides of the market. Shorting stocks allows for diversification. It allows investors to take advantage of mis-priced securities. It brings truth to the market through the context of accurate price discovery. Short interest often acts as support when stocks are falling out of control. Shorting is a NECESSARY cog in the wheel of finance to keep equilibrium in place.

    When was the last time you were short a stock that doubled overnight before you had a chance to cover? Ii’m sure it has happened to someone but those times are EXTREMELY rare – and almost always involve shorting a penny stock which has no liquidity and should only represent a small portion of an account (if any portion at all).

    The idea that shorting stocks is inherently more dangerous than buying stocks, is morally wrong, or is a poor investment tool drives me nuts! (can you tell? :-) It especially bothers me because too many investors that COULD have protected themselves through this turbulent market period have decided NOT to because they heard that shorting was risky, or wrong.

    To be sure, one must understand the risks involved with trading ANY security – from the long OR the short side. I would argue that too many individual investors enter the market without the proper knowledge base to make them competitive or keep them safe. But that’s what sites like seeking alpha and ZachStocks.com are about – giving investors tools and the proper understanding to be able to make informed and profitable decisions.

    You’re reference to using puts is well taken. But options traders get nothing for free. The reduced risk in buying puts comes with a cost – that would be time decay if buying puts outright – or any number of other risks if a more sophisticated approach is taken.

    But that brings me to a good point. When I recommend shorting a particular instrument (or when Ritholtz, Trader Mark, or Cramer makes a recommendation) the individual trader or investor can apply the best tools that he personally would like to use for that instance.

    So if you like the idea of shorting retail – GO AHEAD and buy puts – or sell the calls – or set up a backspread strategy – use futures – use straddles, strangles, condors or butterflys (option strategies). That’s what individual traders do! They take the tools available to them and create a trade which matches their risk tolerance, their aggressive or conservative approach, that ties with their existing positions, and that meshes with their view of the world.

    OK – NOW that I’ve got that off my chest – thanks for the comment – thanks for reading – I really mean that.

    Good points on the retailers going out of business (although I think the smaller pie will more than make up for the fewer eaters). We live in dynamic times and risk must be carefully monitored and managed to ensure financial survival. The point is that as individual traders, we should use the tools available to us in order to protect and grow our investments.

    The best of success to all…

  3. Mark Humphrey Says:

    I have shorted a couple of banks with small bets for the last few months, covering on rises; they keep on rising. So my timing has been stupid. But as an eternally hopeful pessimist, I suspect we may be nearing a turning point, because:
    1) loan resets and reduced business spending guarantee rising defaults on residential and commerical loans.
    2) Banks booked big additions to earnings directly as a result of the big one-time increase in the value of securities; that’s behind us.
    3) If long term rates rise, refinancing fees will decline (although loan spreads on new stuff will get more profitable). If they decline, business would be getting softer.
    4) Both banks I follow have diluted shares with big stock offerings; investors apparently think this is good news. I think more such good news lies in the future.
    4) Both banks have greatly reduced their credit loss provisions as % of total loans. Both have big commerical exposure; one also has big holdings of municipals.
    5) The Fed has slowed the rate of growth of the money supply from torrid to moderate. If they continue this policy, it guarantees at some point declining business profits, tougher banking, softer stock prices.

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