Friday’s dismal retail sales report was largely overlooked as the market continued it’s oversold bounce.  But despite the strength in the broad averages, the fundamental data in the report was concerning for both business owners in the retail sector as well as investors who have bid prices of retail stocks significantly higher over the past few quarters.

The big decline cast new doubts about the strength of the economic recovery.  Consumer spending accounts for 70 percent of total economic activity.  Economists are concerned that households will start trimming outlays as they continued to be battered by high unemployment and a swoon in stock prices. ~AP

Certain retail stocks have already begun to price in a slowdown in retail sales…  For instance, Abercrombie & Fitch (ANF) has already lost 30% of its market value from its high in April.  Still, other expensive apparel companies such as Lululemon Athletica (LULU) are still trading near their highs and appear to be vulnerable.

The decline in May sales reached 1.2% which was the largest decline since September and the first significant piece of negative news for retailers.  I would be more inclined to sell (or short) any rallies in the retail sector.  Investors will likely place a lower multiple on these stocks given the uncertainty ahead and the significant risk the that US consumer will continue to pinch pennies and reduce spending.

According to Bespoke, Tuesday’s market action was the second worst start to June in the last 50 years.

Only the first trading day of June 2002 was worse with a decline of 2.48%.  Below we highlight all first days of June that have been down over the last 50 years.  We also provide the index’s performance through the end of the month.  For Junes that have started the month down, the S&P has averaged a rest-of-month decline of 0.53%.

Take a look at the table and you will see the closest two data points led to some very rough returns.

Considering the fact that we just completed the worst May in 50 years, it is clear that the market is vulnerable and investors  (professional and retail alike) are pairing back their risk exposure and looking for safety.

Consumers remain under pressure and if inflation and/or  unemployment statistics begin to tick higher, the pain will be felt not just on Wall Street but more importantly on Main Street.  Investors should be looking for defensive businesses that can survive and even thrive in a weak environment for consumers. Direct payday lenders like First Cash Financial (FCFS) and Cash America (CSH) may be worth watching as they have backed off in recent months but are fundamentally still relatively strong.

The last few weeks have been difficult for many retail stocks – and particularly challenging for investors in the recent IPO of Express Inc. (EXPR).  After being offered to the public at $17.00 per share, the stock has lost about 15% of its value and hit a new low in light trading this morning.  Express is a specialty apparel chain with 573 retail locations spread across the United States.  Originally a part of Limited Brands (LTD), the majority of the company was purchased by Golden Gate Private Equity Inc. in 2007.  The IPO is the first step for the private equity company to cash in on its 3-year investment.

The IPO was managed by Merrill Lynch / Bank of America (BAC) and Goldman Sachs (GS). With such a diverse retail and institutional platform, one would have expected the shares to be placed in the hands of long-term investors and priced at a discount to allow for an initial increase in the share price.  But the environment for retail stocks has been extremely difficult and institutional investors have been offloading risk at a steady pace this month.  At this point it seems that the selling shareholders got the better end of the deal – liquidating part of their position at $17.00 per share.

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According to the terms of the prospectus, there were roughly 16 million shares sold to the public of which 10.5 million were primary (sold by the company to raise  capital) and 5.5 million were sold by private shareholders.  However, when looking more carefully at the deal, this statistic is a little misleading…

Express essentially DID receive $170 million in proceeds from the deal which it used to reduce outstanding debt.  However, it should be noted that the outstanding debt is actually owed to several subsidiaries of the private equity firm that purchased the brand in 2007.  So after passing briefly through Express’s balance sheet, the funds will then be distributed to the selling shareholders in the form of a debt repayment.  Express will be left with $368 million in long-term debt and roughly $67 million in cash.  The pro-forma balance sheet has stockholders equity at $89 million – which implies a 413% debt to equity ratio – not exactly a solid balance sheet.

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But despite the shaky circumstances with which this stock began its publicly traded days, I expect EXPR to find a floor near $14 and begin to trade higher.  One of the primary reasons is because only a small portion of the stock was actually liquidated in the IPO transaction.  Sixteen million shares were sold to the public, but the number of shares outstanding is closer to 89 million.   That means Limited Brands and Golden Gate Private Equity still hold the majority of the stock and will see the market value of their investment rise and fall with the fortunes of the stock.

Once a private equity firm has begun to liquidate its position, they usually don’t wait too long to follow up by selling the remaining shares.  With the negative reaction to EXPR’s stock there is even more of an incentive for the company to find a “graceful” way of exiting this position.  So it may sound counter intuitive, but one of the best ways for Golden Gate to liquidate the rest of its position is for the company to step in and support the price of EXPR – and if they are going to take this action they need to act quickly!

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Supporting the stock at this time when the market is attempting to rebound will be key.  If EXPR begins to trade back towards the $17.00 IPO price and holds a stable pattern, then Golden Gate stands a better chance of selling its remaining shares in a secondary offering.  But if the stock is allowed to fall from here, there will likely be no market for quite some time.  So the stakes are high and the amount of capital at risk is not trivial.

It may be a little too cute on the trading side, but with retail names showing some relative strength over the past few days, I expect EXPR to be good for a trade higher.  The potential return is somewhere in the neighborhood of 10% to 12%.  But this can be painted against a relatively low-risk backdrop.  If I were to enter the trade later this week, I would place a stop just below $14.75 or so – exiting the trade if the rebound in EXPR doesn’t take place immediately.  Setting up a short-term trade in an improving market with capped risk is one of the better ways to play a short-term rebound and I think the general negative sentiment in the retail area could be temporarily lifted as the illusion of financial stability comes back into this market.

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

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Shares of Blue Nile Inc. (NILE) have broken decidedly lower after the company issued its first quarter earnings report last week.  Sure, the overall market was weak and helped add emphasis to the decline, but the outlook for this speculative retail stock continues to be anything but shiny.  We continue to hold a significant short position in the ZachStocks Newsletter portfolio as the outlook does not appear to justify the price.

First quarter earnings came in roughly in-line with expectations at $0.16 per share.  This was good for a 23% increase over the earnings figure for last year.  Revenue narrowly missed expectations with sales coming in at $347.5 million as opposed to expectations at $348.9 million.  The difference is minuscule, but the failure of NILE to beat expectations is what will catch investors eye and likely cause concern.

Similarly, the guidance issued by management came in roughly in-line with expectations as management expects to generate $1.01 in earnings this year.  At Friday’s close – even after the sharp decline – NILE’s shares were still trading at nearly 50 times the expected earnings for this year.  It appears investors are still expecting great things out of the online jeweler.

Despite the perception of the jewelry industry collecting thick profit margins, Blue Nile appears to make a very small profit relative to its sales levels.  While the company selectively displays a 21.3% gross profit margin for the first quarter, the overhead expenses significantly reduce profits.  Total net income was $2.4 million compared to sales of 74.1 million – so investors realize just a 3.2% profit margin on the company’s sales.

Given the high multiple on the stock, I would expect a much larger return on company revenue.  Despite the luxury image, Blue Nile is basically a commodity retailer – buying diamonds and other jewelry, and turning it around at a small increase in price.  And without a showroom and pushy sales staff that is usually present in brick and mortar distribution networks, NILE can only compete on a price basis.  Basic economics say that this type of business must focus on volume instead of price – and sketchy sales growth over the last two years, the high stock multiple seems unjustified.

There are certainly some positive issues that could eventually help to support the stock.  NILE is sitting on an ample supply of cash with virtually no debt.  The company finished the first quarter with $47.2 million in cash.  Management has been using the cash to repurchase stock – and over the first quarter the company repurchased 292,100 shares at an average price of $52.04.

Usually, I would be a fan of a company using cash to repurchase shares.  The net result is a lower share count which can be accretive to investors.  But with the company also paying $50 for every dollar expected in earnings this year, the purchase price appears steep even for a company buyback.

Today’s broad rally in the market may be a gift for traders interested in shorting NILE but those who missed the break last week.  As I write, shares are up 2.5% on very light volume.  But looking at a larger picture, the stock broke below key support areas near $54 last week and is likely to test the February lows at $45 in the near future.

Ultimately, I believe NILE could trade back in the low twenties with an outside chance at dropping to “teenage” status.  If investors begin to realize that the middle class consumer is having difficulty, and correctly view NILE as a company that caters to normal working people instead of a luxury demographic, shares could begin trading at a multiple that is more akin to a low-margin retailing business.

New short positions should likely place a buy-stop order above $56 as a rally back up to this level would call the timing into question.  When trading short positions, stops are important as capital should be protected and losses managed.  At this point I view the trade as risking roughly $5.00 for the potential to capture $25 on the decline.  The risk appears overwhelmed by the opportunity for this name to trade substantially lower.

FD: Author has a long position in the ZachStocks Newsletter portfolio

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Investors in BJ’s Restaurants Inc. are optimistic souls.  After all, the company has been able to show strong earnings even through the financial crisis, opening new stores during a time when consumer spending was very much in question.  And as discretionary purchases have grown over the past few months, the stock has become even stronger, testing its pre-crisis high near $27.50.

Pizza and beer are a good combination and BJ’s appears to have perfected the art of offering an exceptional neighborhood “feel” while still expanding the number of locations to 94 at last count.  Over the last four quarters total revenue has increased anywhere from 9% to 19% (year-over-year).  The strength is both due to existing restaurants seeing improving sales, and new restaurants coming online.

In the first quarter, BJRI opened two new locations.  Management is guiding for an additional 2 openings this quarter with expectations of four new stores in the third quarter and another 2-3 in Q4.  So for the full year, there will be 10 to 11 new stores in play and generating revenue for the company.

While management seems pleased with the rate of growth, I am worried that investors are setting themselves up for disappointment when it comes to the future growth of the company (and the stock price).  Expanding by 10 to 11 new stores is hardly a “high-growth” rate of openings – basically an 11% to 12% store base expansion.  This rate would be good for a well-established chain like Applebee’s, but is not very impressive for a small pizza chain with high hopes.

Don’t get me wrong – I believe that in the current retail environment, it makes a lot of sense for a company like BJ’s to be very conservative in how many stores they open.  If consumer spending becomes weaker as a result of high unemployment and the potential for stimulus measures to decline, then BJ’s will want to keep a higher cash balance and be very selective about where it opens new stores.

But investors appear to be much more aggressive in their growth assumptions.  Currently, the stock is trading at 36 times expected earnings for this year.  This during a time when same-store-sales are increasing by just 4.4% and most of the growth should come from new locations, not from better revenue in existing locations.  In fact, management recently unveiled a new menu with smaller items at lower prices.  The decision may help the company keep customers loyal, but will likely result in lower profit margins for the entire firm.

Shorting BJ’s may be a bit of a dangerous game because the float is very small (only 14 million shares are actively traded), which could lead to a “short squeeze.”  This occurs when too many short sellers have negative positions and the stock begins to rise.  At times like this, traders can feel trapped as they are forced to buy back shares which lead to higher prices.  But after a short squeeze in less-than-liquid names like BJRI, the opposite can easily occur with the stock dropping sharply as fundamental metrics lead to a much lower price.

Based on my concern for  the retail sector, along with my respect for the company and the conservative approach management is taking, I believe BJRI could easily command a multiple of 20 times this year’s earnings.  Unfortunately, that metric would bring the stock to about $13.60 which would be a significant decline from current levels.

Aggressive traders might want to consider buying puts on the restaurant chain which would allow for the volatility associated with a smaller-illiquid name, but still give traders an opportunity to capitalize on a potential decline in the stock.  The July 22.5’s look attractive to me, trading at 85 cents.

The environment for today’s retail investor is quite treacherous.  With high expectations for growth and inflated prices, there is plenty of room for disappointment – resulting in lower prices.  I would avoid long positions in the group, but if you must have exposure, be sure to keep close stops or hedge against potential losses.  Once earnings season is over, there is a good chance many of these high-momentum names will back off quickly.

FD: Author does not have a position in BJRI

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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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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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The retail sector has been particularly strong as it appears that strategic defaults are driving a significant amount of spending.  Optimism may also be increasing which is driving consumers to be more willing to spend – and consequently driving savings levels lower.

While consumer cash flows may be increasing towards discretionary purchases, the value of many discretionary spending stocks appears to show not only the expectations that the consumer will remain strong, but also proves that Wall Street to a large degree buys deeply into the recovery theory.  Take, for instance, the speculative price on OpenTable Inc. (OPEN), a computerized reservation and table management system for restaurants.

The business model is sheer genius for strong economic times.  Restaurants are able to subscribe to Opentable’s software on a monthly basis and gain not only publicity and exposure, but also better manage their flow of guests during busy periods.  Diners also have an advantage as they are able to book reservations quickly and easily, view information about different restaurant choices in their area, and even view a menu before deciding where to eat.

Opentable relies on economies of scale to cover overhead expenses and generate attractive earnings.  At the end of the fourth quarter, there were 10,850 restaurants in North America using opentable’s program as well as an additional 1,501 restaurants internationally.  According to the fourth quarter press release, there were over 12 million diners seated during the period which was up more than 40% from the fourth quarter of 2008.  Tapping into today’s mobile handset market, the company recently announced that it had seated its 2 millionth diner through booking over a mobile device.

Analysts believe that the future is bright for the company as well.  The current estimate is for earnings growth of 45% in 2010 to 45 cents per share.  While it seems almost impossible to predict dining trends in 2011 (given the uncertainty of the current economic climate) analysts are handicapping another 44% increase to $0.69.  The commentary out of the company is positive – to be expected – and management expects a positive year ahead.

We’re energized by the opportunities in front of us and are focused on helping our restaurant partners grow and providing diners with the convenience of online, real-time restaurant reservations.”  Jeff Jordan, CEO

While I’m impressed with the way this business has been built – and will likely use the service myself in the future – from an investor’s standpoint I have some significant concerns.

The first potential issue is that there are basically no barriers to entry for competing firms.  Anyone with a few thousand dollars or some technical know-how could replicate the main components of OPEN’s software.  There doesn’t appear to be anything keeping a copycat entrepreneur from creating a similar business platform which would eat into the niche that Opentable has built.  And as OPEN becomes more successful and generates significant profits, the environment for competitors will become even more tempting.

Secondly, management currently owns 61% of the company.  While I typically like for management to have a significant stake in a growing business, the controlling ownership makes it very difficult for shareholders to implement any changes should they disagree with management over particular business issues.  At the same time, management appears to be slowly liquidating shares through exercising options and selling the stock.  It makes sense for officers to be able to capitalize on the company’s success, but if this trend increases it could become more concerning.

Finally, the stock is trading for an overwhelming 80 times 2010 earnings – much more than most investors should be willing to pay even for a great growth opportunity.  I definitely expect OPEN to trade at a fat premium due to its unique business and the success it has enjoyed so far.  But the market is essentially projecting 40% growth for several years and any disappointment could quickly send shares back down to the $25 area where it was trading in January and February (or potentially even lower).

Trading is a difficult and sometimes counter-intuitive game.  Over the weekend I wrote a piece on the difference between value-based investing and technical trading.  This piece might be helpful in analyzing the potential trend for OPEN over the coming weeks and months.  At this point, OPEN has strong momentum and may very well continue trading higher as investors brush aside risk concerns.  I’m not brave enough to step on this train – I believe the risk is too great at such lofty valuations.

But shorting this stock is a dangerous undertaking if timing is off.  I would keep OPEN on the watch list for now and look to short after a failed breakout attempt (which may be forming now at the $39.00 level) or possibly on a break below $35.  It will be important to confirm that the trend is in fact lower, and that there is an appropriate stop point to minimize risk.  OPEN will likely turn out to be an excellent short sometime this summer, but traders must first have the patience to wait for it to falter.

FD: Author does not have a position in OPEN

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