Another Way to Play

At the height of the US housing boom, my colleague Yiannis Mostrous made one of the more prescient investment calls I’ve seen. Writing in the advisory he co-wrote at the time, Wall Street Winners, he recommended a short sale of giant, government-backed mortgage lenders Freddie Mac and Fannie Mae.

Short selling is essentially betting on the value of a stock, commodity, bond or index to drop by first selling it, with the intent to buy back later. This is accomplished by effectively borrowing the stock from your broker. Short sellers are required to post collateral, but only 50 percent of the value of the stock borrowed and sometimes less.

At the time, the advice to bet on a drop in Fannie and Freddie no doubt seemed foolish to many. After all, these companies were in a period of extremely rapid growth, and the US mortgage market was entering a hyper-boom phase. The stocks had been on fire and it looked as if the sky was the limit. Moreover, both had implicit US government backing. What could possibly go wrong?

Of course, we’ve since found out just what can go awry under the wrong circumstances. As it turned out, these organizations were just as caught up in the mortgage and housing market crisis as the big banks. In fact, their errors were likely compounded precisely because they enjoyed that assumed government guarantee, combined with the generally laissez-faire approach of Bush administration regulation.

Recovery remains elusive. This week, for example, former Federal Reserve Chairman Alan Greenspan predicted the US housing market wouldn’t hit bottom until sometime in 2009--and he was trying to be optimistic in order to discourage further government bailout action.

Both Fannie and Freddie had pretty much flatlined near their highs when Yiannis made his call. Today, they’ve crashed all the way to single digits, and haven’t fallen further solely because of US government assurances that they won’t be allowed to fall into Chapter 11.

In retrospect, what made these companies such fantastic short sales were basically three factors. First, the overall stock market was at a high level, which meant high valuations that were easy to disappoint. Second, Fannie and Freddie themselves were at very high valuations, so expectations were extremely high and the margin for error was very low. In other words, it didn’t take too much bad news to knock them off their lofty perches.

Finally, Fannie and Freddie were vulnerable because the real estate cycle was reaching an extreme in the US. Property “flipping,” the proliferation of subprime and Alt-A mortgages, the home building boom and bidding wars for existing homes were all signs of a market rapidly overheating and ready to cool down.

Just as a bull market gets people interested in buying stocks, the tremendous success of high profile short sales like these has increased the popularity of short selling. And the further the market has fallen, the greater the urge, as patience wears thin and investors scramble for ways to reduce bear market erosion of their portfolios.

Thus far in 2008, all the major US stock averages--except the Dow Jones Transports Average--are lower, most by double-digits. Foreign markets have fared worse still. As of this morning, the European stock Dow Jones STOXX 600 is off more than 21 percent. The equivalent Asia Pacific Average is down 18.5 percent.

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Ironically, some of the worst damage has been done to markets that were hottest earlier in the year, namely commodity-driven markets. Russia’s Dow Jones Russia Titans 10 is off 24.1 percent. Australia is down 21.4 percent. Even Canada, a strong relative outperformer thus far, has seen its S&P/Toronto Stock Exchange Index slip 3.4 percent. Meanwhile, despite its extremely strong economy up to this point, China’s Dow Jones CBN China 600 index is off by more than 50 percent.

These year-to-date losses are in addition to what we saw starting in mid-summer 2007. And as I pointed out last week, the weakness in the financial sector points to further downside in the months ahead.

This is undeniably a bear market. And although things haven’t gotten as bad as they did in 2000-02--the last real downturn--there are still almost certainly losses to come.

Bear markets always end. And this one will, too, almost certainly long before most investors and, particularly, the financial media has recognized the turn. That’s simply the way it always works.

The good news is stocks of strong companies will recover their losses and then some, as long as they hold their own as businesses during the ongoing stress tests. The bad news is investors who hold on for recovery will have to endure the ups and downs. And should those underlying businesses falter, their stocks will crater and possibly never recover.

Certainly no one likes to lose money. Sometimes, however, there’s no better alternative other than just riding things out. As a metaphor, one of my favorite sports is whitewater rafting, which I was able to do in the Sierras last weekend following the San Francisco Money Show along with my son and brother-in-law. Our trip was on the Middle Fork of the American, a mostly moderate river that’s punctuated by potentially life-threatening major rapids.

The key to successfully navigating the maelstrom was a guide who knew where the raft needed to go on the river, so we followed his instructions. On more than one occasion, we were told to “get down” in the boat, trust that we were on course and simply ride the rapid to its end. That can be a scary feeling, unless you’re sure of your equipment and, of course, your guide.

In my view, the best guide in this market is company earnings. We’ve just come through an exhaustive reporting season, at least for me. Some companies have faltered. More often than not, however, those that have been delivering continued to post strong results.

The market, of course, has treated their stocks in a variety of ways. The common thread they share, however, is their underlying businesses are weathering the stress tests of US economic weakness, rising raw materials costs and tighter credit markets. As long as they do that, they’ll hold their own in this tough environment. And more important, their stocks are a lock to wipe out any losses they’ve suffered during this bear market.

A generous distribution can help pass the time and ease the pain during stock market turbulence. And there’s no better guarantee that one will continue to be paid than solid and growing earnings.

There’s also serious money to be made in bear markets by buying battered down stocks and holding on until the overall market bounces back. Back in mid-2002, for example, I bought a basket of standard issue blue chip stocks, including the likes of General Electric. Most haven’t been barn burners since. But all have rewarded me with nice gains for doing nothing more than simply betting they wouldn’t go belly up.

Buyers of big bank stocks such as Citi back in the early ’90s did even better in ’98. Again, the bet was simply on the giants’ survival. All you had to do to cash in was be willing to wait out further downside if it occurred.

This time around, there are numerous potential candidates for this kind of trade, from financials to auto companies and airlines. In my view, buying a couple big banks probably makes the most sense for conservative, long-term investors.

With an article in today’s The Wall Street Journal casting doubt on even Wells Fargo’s balance sheet, there’s more bad news ahead for the sector. The important thing is this sector is absolutely essential to the US economy, and that alone ensures ultimate recovery. You just have to buy and then “get down” to ride out whatever comes up.

As Yiannis’ call on the mortgage giants demonstrates, you can make huge money selling stocks short. Entering a short position in Freddie at its drawn out peak, for example, would have multiplied the value of the collateral several times. And given how far the averages have fallen over the past 13-plus months--and how many other companies have blown up--there have been plenty of opportunities for successful shorting this time around.

Unfortunately, it’s not as easy as it sounds. In fact, most people who short stocks wind up losing their shirts. For some, the culprit is simply that they’re not used to dealing with the leverage involved. On 50 percent margin, for example, every $1 move in a stock has a $2 impact on the value of your position. If a position moves enough against you, you’re then faced by margin calls, which require you to either put up more money immediately or close the position.

It’s not hard to see that this is a fundamentally different mentality than buying and holding quality stocks. Even the wealthiest can’t afford to be too wrong for too long. With leverage, you’ve literally got to be right on both the direction and the timing to make it work. And most people simply don’t have the temperament for it.

There’s another big reason that most people lose money shorting: piling on. Rather than research a potential falling star, most investors confine their targets to stocks that have been weakening technically.

There are plenty of ways to put price and volume charts to work. Some traders, like my colleague George Kleinman, have built exceptional records doing it. No one who stays in the business long, however, makes it without refining these basic tools with their own experiences and techniques.

Those who simply base decisions on the same charts everyone else is looking at will succeed as long as the trend is in play. And if the fundamentals of a company really are coming apart, that trend can take a stock all the way down and out. We’ve certainly seen that happen many times over the past year, notably in the mortgage market with such former hotshots as American Home Mortgage.

The now expired US government restrictions on shorting major banks was a pretty clear indication of how fearful policymakers were that shorting would further depress share values and confidence in the financial system. With so many interconnected relationships in banking, falling share prices alone can threaten business health.

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In most industries, however, short selling alone will only bring down the business if the company is in need of raising capital. If the underlying company is generating all of its needs for cash, it will keep current on its loans and won’t need to issue more stock or debt. It may even elect to strengthen its financial position by paying down debt.

Over the past year or so, virtually every sector has eventually been taken down. High flying energy and raw materials stocks, for example, were the undisputed biggest winners in the first half of this year, but many have given it all back and more since the beginning of July.

As at least one speaker at the San Francisco Money Show noted, there really haven’t been any safe havens. Everything has taken a hit at one time or another, even companies that have posted solid earnings.

In my view, the lesson for those on the long side of the market is that you have to be diversified among stocks and sectors. You have to be balanced among those sectors, as today’s winners and losers will switch roles several times over this bear market. You have to focus on quality businesses to ensure ultimate recovery of your portfolio, and you have to be willing to dump companies where the underlying business starts to deteriorate to avoid the real black holes.

The lack of safe havens has even more profound implications on the short side, however. Mainly, it’s very easy to confuse near-term stock market weakness for the kind of real underlying business weakness that really takes stocks down and makes for successful short selling.

The result is a lot of people have been piling on stocks that have been weak on the outside but are still strong on the inside. They short the stock using margin. Then some fundamentals-based event showcases their target’s underlying business strength. The stock starts moving higher, the losses pile up and they’re ultimately stopped out for a big and leveraged loss.

The way this phenomenon shows up in the market is as follows: A stock declines slowly over a period of days--or even weeks--as short interest builds. If it goes on long enough, the short sellers start to feel more confident and will sell even more, driving the share price down further. Then the news comes out, blowing the short sellers out of the water with stop losses and margin calls and the stock shoots up 10 to 20 percent in a day.

This appears to be what happened to two higher stakes Utility Forecaster recommendations: Atlantic Power Income Fund and FairPoint Communications. Both stocks looked fatally weak until they reported their second quarter earnings. Both reported great news that affirmed business plans were on track and dividends were sustainable. And anyone who was short their stocks got their heads handed to them.

For Atlantic’s part, management was able to show that its cash flows are healthy, growing and stable. It also demonstrated it has the cash to reduce debt as promised with the prospective buyback of 8 percent of its income participating securities. When it showed those numbers, it was obvious the company is on solid ground and its distribution sustainable. The share price began to rise in earnest and whatever short positions there were got squeezed.

In FairPoint’s case, the key was that the bar was set pretty low for earnings. Activity in the stock for the week prior the announcement clearly indicated a large number of investors were expecting something ready bad, like a dividend cut. What they got was indications of progress on the integration of the systems acquired from Verizon and generally solid cash flows. The absence of really bad news pushed the stock up more than 20 percent in just one day, doubtlessly because again the shorts were getting squeezed.

The big picture here is that, even in a bear market like this one, short selling is no easy road to riches. Even doing your research doesn’t guarantee success any more than it does when you buy stocks. And you’ve got to be prepared for leverage’s double-edged sword. Without research, however, you’re practically guaranteeing failure, and you will fail unless you’re very, very lucky.

So where are the best short sales now? Certainly the market has continued to gyrate wildly with a downside bias. The news on the economy has hardly improved, as previously steady employment has begun to weaken and the dangers in the financial system seem to appear daily. And of course, even hitherto strong sectors of the market have been summarily beaten down, including the formerly red hot energy and raw materials markets.

That would appear to be the best possible environment for short sales. Ironically, it’s one of the worst for the kind of really successful trades, such as Yiannis’ call on Fannie and Freddie.

Basically, none of the three conditions that made the pair such good shorts are still in effect. We’re no longer at a high level for the stock market in terms of valuations. In fact, the bear case has become purely that declining earnings will pull down share prices further in a recession.

That certainly can’t be ruled out, and it’s why I’ve paid so much attention to earnings in my advisories Canadian Edge, Utility Forecaster and Vital Resource Investor, which I co-edit with Mr. Mostrous. It is, however, a fundamentally different situation than a year ago, when even strong earnings could pull down prices because of high valuations that allowed no margin for error.

Second, the economy is no longer anywhere close to overheating. Raw materials prices haven’t fallen nearly as much as they have in past cycles. That’s because infrastructure buildout remains a critical need in the developing world and, in absolute terms, countries such as China are more important to global demand for raw materials from copper to iron ore. But overall economic growth has dropped off, and inflation appears to have cooled a bit as well.

Finally, the three major stress tests facing companies--weak growth, rising raw materials prices and tight credit--have now been in effect for a year. They may intensify, but it’s hard to argue the most vulnerable sectors have not already had their comeuppance. And businesses whose earnings have thus far weathered the storm are increasingly less likely to crack.

In the utility and telecom universe, we’ve seen major damage to unregulated communications companies such as IDT, which has fallen to less than $2 a share from over $10 a year ago. Despite swirling takeover rumors and a major restructuring effort by management, Sprint’s operations are also still eroding, and the shares are now at barely one-tenth of their level early in the decade. And Qwest Communications is less than half its 52-week high, arguably pricing in already its relentless declines in earnings, revenue and basic phone connections.

The US communications directory business has been in complete meltdown mode. Verizon spinoff Idearc has now broken the $2 per a share level, as its advertising revenue continues to drop.

In the power sector, Constellation Energy’s big decline in the past month illustrates some of the uncertainty for companies that have stuck to the business of energy marketing. The three step credit ratings downgrade needed to trigger collateral needs is highly unlikely without some catastrophic worsening of economic conditions, so the damage is likely done with this one. But the news does send a cautionary note for other companies that are big in this business, such as Reliant. In fact, a large number of companies saw marketing operations swing to losses.

The common thread of all of these stories, however, is the problems are well known. There could be more damage, but a great deal has already been done. In sum, shorting them is hardly a ground floor opportunity. And the same can be said for the extremely challenged and volatile-priced financials, which seem to stage up or down multi-percentage point moves daily.

The bottom line is the best approach to short sales now is likely some kind of trading strategy. That means having the discipline to take small profits when you get them. Candidates would include the sell-rated stocks in Utility Forecaster and Canadian Edge.

In my view, however, you’re going to make a lot more money from this bear market by continuing to position for the inevitable recovery. That means sticking with strong business that are supporting good dividends. It means picking up some beaten down fare for as comeback plays. And it means dumping any stocks, bonds or preferred shares you own of companies that appear to buckle under the ongoing stress tests. After that, you can “get down” and hang on for what continues to be a wild ride.

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat if the federal government.

Join me and my colleagues Neil George and Elliott Gue for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011362 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Gregg Early, Neil George and Elliott Gue.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 877-238-1270.