Credit and Debit card issuers, along with transaction processors were sharply lower on Friday after a Senate vote included restrictions on the fees that can be charged for these transactions.  The vote essentially allowed the measures to be included in the Financial Reform bill and the regulations could have a dramatic impact on the profits for many of the companies involved.

Transaction Processors

The two most important companies affected by this bill are Visa Inc. (V) and Mastercard Inc. (MA).  Both stocks were down sharply on the news – and both traded on heavy volume indicating institutional selling was extreme.

Visa is currently trading at about 20 times expected earnings for the year ending September, 2010 which is not an extremely rich multiple.  But the technical pattern is very sobering with Visa dropping below the 200 day average on huge volume.  Most investors are banking on the fact that Visa will see long-term growth rates near 20% as international expansion generates revenue growth – primarily from emerging markets.  But the US is a significant portion of the company’s established business and if the senate bill cuts down on fees for debit and credit cards in the US, it will likely lead to at least some pricing power in international markets as well.

Mastercard is in a similar position except for the fact that the stock has a much lower multiple.  When it appeared that consumer spending would be constrained as a result of higher unemployment, many analysts argued that Mastercard and Visa would continue to generate large profit increases with little risk.  The fact that these companies do not take on credit risk was a major benefit as opposed to the banks who actually lend to consumers and face the risk of default.  If the transaction fees are more heavily regulated and margins are constrained, that may significantly reduce the appeal of these companies to investors.

Discover Financial Services (DFS) is one of the short positions currently held in the ZachStocks Newsletter Portfolio.  Currently, we have a 4.4% profit in the position and I expect that number to increase over the next few weeks.  Analysts are expecting 309% profit growth in 2011 as the company faces fewer defaults and the economy becomes stronger.  But as the financial reform bill makes its way through the legislative process, there could easily be more unfavorable surprises for lenders like DFS – and the uncertainty abroad doesn’t help matters either.

The pattern on American Express Co. (AXP) looks quite disturbing as the stock has given back all the gains from its breakout in April, and volume was strong on the gap lower Friday (although not nearly as pronounced as Visa and Mastercard).  AXP has a significant debt level which is not a concern when markets are functioning properly, but could become a much bigger issue if liquidity freezes up and delinquencies rise.  A PE of 13.5 is not exceptionally expensive, but if analysts expectations for 2010 turn out to be aggressive, the intensity of selling could pick up.

What’s in YOUR wallet? Capital One Financial Corp (COF) has put together an incredible marketing effort.  But their earnings are just a shadow of what they once were.  With one of the biggest portfolios of consumer loans and credit lines, COF is finding itself square in the cross-hairs of regulators and may very well operate in a confined industry for years to come.  Don’t expect profit to grow significantly after 2010 unless the economy rebounds more strongly than even the most bullish economists expect.  The stock appears vulnerable after giving back gains from its most recent breakout and I wouldn’t be surprised if the current estimates prove too aggressive.

The bottom line is that regulatory uncertainty is a cloud that will continue to hang over companies associated with credit and debit transactions.  Long-term, regulations could eventually backfire on consumers, shutting down the availability of credit lines and inadvertently helping business lines such as payday cash advances.  The financial reform bill could be just as damaging as the healthcare bill when it comes to some of the key financial companies.   Surely, something needs to be done to protect consumers – and many of these companies have lost all sense of decency and ethics when dealing with their customers.

Regardless of what may look like reasonable (or even attractive) multiples, I wouldn’t take long positions in these stocks right now, and any rebound next week could serve as an opportunity to test some small short positions.  Given how far these stocks have rallied in the last several quarters, some profit taking is entirely possible, and significant declines could end up causing panic and additional selling.

Author has a short position in the ZachStocks Newsletter portfolio

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Shares of Priceline.com Inc. (PCLN) are off sharply in early trading after the company announced earnings for the first quarter.  On the surface, the numbers were strong.  Revenue for the first quarter eclipsed a half-billion coming in at $584.4 million.  This is a 26.5% increase over revenue for the first quarter of 2009.  Earnings were even more impressive with EPS at $1.70, good for a 56% increase.  The earnings figure beat consensus estimates by 4 cents, but the revenue came in about 2% below expectations.

While the historical numbers should be viewed positively (although analysts have become accustomed to the company actually beating expectations), the forward guidance was concerning.  Management is guiding investors to expect earnings between $2.50 and $2.70 for the second quarter.  This is an important quarter for the company given travelers tendency to book summer vacation trips.  Revenue is expected to increase 18% to 23% which is significantly below the 25.8% average expectation.

Guidance for the second quarter still reflects growth for the company, but challenges are certainly pressuring that growth:

The Iceland volcano caused widespread disruptions in air travel which resulted in a significant increase in hotel room cancellations for our Booking.com business. Civil unrest in Thailand has substantially impacted hotel room reservations in Thailand, which is a key market for Agoda and Booking.com’s Asia business. Lastly, sovereign debt concerns in Europe have resulted in a significant decline in the value of the Euro as compared to the U.S. dollar which adversely impacts our financial results as expressed in U.S. dollars. ~Jeffery H. Boyd, CEO

Priceline’s stock price has been extremely volatile over the last week.  This is in stark contrast to the sustained positive move which investors have enjoyed for well over a year.  After setting a low near $45 in December of 2008, the stock has rallied more than 500% to its recent high above $270.  And despite the sharp increase, the earnings multiple is not overwhelmingly expensive at this time.

Using the forward consensus earnings expectations of $11.21 for this year (which will likely be reduced after the earnings report), the stock is trading at just 18 times forward earnings.  But while that number may appear reasonable, I expect these expectations to be reset lower and potentially continue to be adjusted as we move through the year.

Debt issues in Europe are almost certain to continue to be a problem.  Yesterday (Monday) the Euro made very little progress against the dollar despite the fact that a $1 trillion dollar bailout package was put into play.  If the Euro can’t rally on this type of stimulus, then it is difficult to see what would pull it out of its decline anytime soon.

On top of that, the global consumer’s confidence may quickly be shaken as we deal with sharp volatility in the market again.  For over a year, a rising stock market (both domestically and abroad) has led to consumer confidence, and in turn has helped to propel consumer spending on many luxuries including travel.  Businesses have become more active travelers too as liquidity and corporate spending has become relaxed.

But if those trends are reversed, PCLN could be very vulnerable to a sharp decline.  If earnings for this year turn out to be 10% above 2009 and 2011 experiences the same type of growth, the market could easily use a lower multiple in the neighborhood of 12 which would yield a stock price closer to $112.  And if earnings actually decline in 2010 or 2011 the stock could fall much farther.

At this point it appears that the risks in owning PCLN far outweigh the possible returns.  While shorting outright at this juncture may be difficult (given intense volatility) active traders could consider selling out of the money calls (and possibly puts too) to capture volatility premiums.  Before engaging in this type of trade, make sure you understand the risks of selling options and have a plan in place to offset your losses if the stock moves against you.

If PCLN rallies back towards the 50 day average, aggressive traders could take a shot at shorting the stock with a tight stop.  The environment is changing for this successful travel business and I expect more weakness in the coming quarters.  As an alternative, investors could also consider shorting Ctrip.com International (CTRP) which could be under pressure both from weakening travel as well as less robust growth in the Chinese economy.

FD: Author does not have a position in PCLN

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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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Shares of First Solar Inc. are off more than 4.5% today as the broad market takes on water and growth investors are punished.  The stock has had a very strong run over the past few months, rising 50% from the low set on February 25th.  The company recently announced earnings of $2.00 per share for the first quarter on revenue of $568 million.  Revenue was up 36% which impressed analysts and management increased guidance for the full year due to strong European demand for its cells.

However, despite the positive outlook and strong execution, I’m concerned that  FSLR could find itself in a trading range – or worse, in a negative trend as investors shy away from growth companies which rely on European customers.

With the financial world’s attention focused on the problems in Greece, and the growing concern that contagion could quickly spread to Spain, Italy, Ireland and Portugal, European commerce could quickly come under pressure.  Germany has been one of the few stalwarts of strength, but even the fiscally conservative country could find itself with serious losses as the government is faced with the task of bailing its neighbors out.

To be sure, the crisis in Europe is nowhere near contained, and it is difficult to handicap the potential danger, and the ways that mounting sovereign debt could affect the broad global economy.

Germany has had one of the most liberal solar stimulus programs, encouraging the use of alternative energy and helping to boost the profits of solar companies that operate across Europe.  My understanding is that stimulus programs were already in the process of being wound down before the crisis truly became big news in Europe.  Now that Germany is more likely to be on the hook for a huge bailout, the stimulus programs are even more likely to be curbed – which could have a material effect on sales levels for solar manufacturers across the board.

As you can see in the chart below, Germany makes up a significant amount of projected demand for solar energy

First Solar is not particularly expensive given its strong profits and past record of growth.  But at 22 times current estimates for 2010 earnings, investors are pricing in robust growth which may be much more of a challenge as the European crisis evolves.  On top of that, FSLR appears to be on the acquisition trail as it announced a purchase of NextLight Renewable Power and could make additional purchases with its leveraged balance sheet.

There are a few positive issues that could help support the price of FSLR.  For starters, the company has little debt which will likely give the firm a competitive advantage if we enter another difficult period for solar.  In this case, acquisitions might be a strong benefit to the long-term value of the company as cash-starved competitors could sell out for attractive discounts as they would be unable to remain solvent under heavy debt loads.

Also, there is the BP oil spill which may add to pressure for more “safe” energy sources.  If oil drilling comes under tougher sanctions, we may see higher demand for solar energy as a result.  Such a move would benefit the entire industry and with FSLR as one of the leaders, it could receive higher levels of new orders.

But today, it appears the safest bet on FSLR is for a lower price.  Speculation is being punished and the solar industry is certainly one with high risks and cloudy visibility.  Investors are likely to bail out of these growth positions until the environment becomes clearer and until that happens FSLR shares could easily lose a third of their value to trade back down to the lows from February.

FD: Author does not have a position in FSLR

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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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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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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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