The Sinking Ship
However, sometimes things can go drastically wrong for companies. As recent market history shows, bankruptcy can occur for even those companies that are presumed to be beyond such an event. Such hubris appears to echo the thinking of the builders of the Titanic - an "unsinkable" vessel.
In other cases, companies with solid fundamentals can see share values soar beyond what most reasonable market observers would regard as appropriate, given their growth prospects and the valuation assigned to comparable companies. Such instances were alluded to in former Federal Reserve Chairman Alan Greenspan's reference to "irrational exuberance" during the height of the "dotcom" bubble. (Read more about Greenspan in A Farewell To Alan Greenspan)
Selling Short: a Way to Play the Downside
Given that such events seem to occur with a greater-than-desirable frequency, investors can sometimes profit from betting on falling as opposed to rising share prices. Indeed, large profit can be realized by regularly scanning the market, looking for stocks in which fundamentals have drastically deteriorated, or valuations have exceeded what rationality would dictate. (To learn more, check out Investopedia's Short Selling Tutorial.)
Theoretically, opening up your investing strategy to include short positions, as opposed to only long positions, doubles the amount of potential profitable stock trades you can find. For example, suppose there are 6,000 stocks listed on the NYSE and Nasdaq exchanges. If you are a long-only investor, you have 6,000 potential profit opportunities from which to filter down to your best picks.
However, if you are willing to perform both long and short trades, you now have 12,000 potential profit opportunities to use in search of your best bets to make. Especially during bear markets, this advantage can prove critical and can go a long way to helping you beat the market.
Your Five-High Short Stack
With that in mind, how can investors determine which stocks will fall in price going forward? Unfortunately, there is no crystal ball, and any number of different analysis techniques can potentially signal that a stock may be set to decrease in price.
One approach is to find stocks that have experienced dramatic price gains upmoves since the market bottom in March, in spite of the fact that their fundamentals are not expected to improve. Stocks with negative earnings and sales trends that aren't expected to show a profit over the next two years would fit that definition - five of which appear below:
| Company |
12 Week Price Change |
EPS (TTM) |
| WEYERHAEUSER (NYSE:WY) |
68%
|
(6.115)
|
| DILLARDS INC-A (NYSE:DDS) |
178%
|
(3.195)
|
| MERITAGE HOMES (NYSE:MTH) |
88%
|
(8.7)
|
| USG CORP (NYSE:USG) |
142%
|
(4.68)
|
| LAMAR ADVER CO (NASDAQ:LAMR) |
184%
|
(0.10)
|
| Data as of market close June 4, 2009 |
For forest products company Weyerhaeuser, the U.S. housing slump has produced a collapse in earnings and prompted a multi-year restructuring process. One part of that process would be to convert the company to a more tax-efficient REIT structure. However, management recently announced that such a conversion would be unlikely this year. Analysts conceded that the company would not be able to manage the cash distributions currently required as a REIT.
Apparel retailer Dillard's recently reported a 12% decline in same store sales for May. Analysts had been calling for a 8% drop.
Final Thoughts
Though there are other methods, this is just one approach to finding a starting point to short potentially overvalued stocks. (Read Buy When There's Blood In The Streets, to learn how contrarian investors find value in the worst market conditions.)
