Four Points on the 'Great Short Trade'

As technicians, fundamentalists (and I am not talking about religious types) and almost anyone else will tell you, the market is trading by its own internal logic that is pretty hard to elucidate. Let me try.

First, Wall Street sees a bottom at yearend and an upturn in Q4 GDP. The seriously foolish see this as a real bottom and a real upturn in GDP; the savvier fools see this as a statistical bottom they can trade and have done so for the past two months. This latter group is not really made of fools - they have just cost my subscribers a lot of money and I am mad at them.

Second, technicians and historians are using past market performance to say we hit a certain bottom, we are going through a retracement to this and a return to that. All based on rational history. Then you ask them about corporate earnings and the multiple of the market and they ask have you seen a good ballgame lately. You then ask them if equity markets have ever risen in the face of rising interest rates and they cough and ask you to leave.

Third, the market is now behaving like one great day-trading pit - a piece of news, let's rally or slide and let's hang on, if you get in before the pop, collect your winnings before the window closes and get ready for the next horse race.

But all of this would not hold, and would serve to push the market up as fast as it has because people want to believe in a good news story, and want the market to go up. The history of the Street since trading started is based on this. Independent of your politics or how you view his initiatives, Obama has proven to be a remarkable, no, an extraordinary leader with outstanding ability to calm people - even those who dislike or hate him - and make them feel better about the future.

This may explain the current market. Now let me present the summary for the bearish view. It all begins - and will end - with housing.

Point Number One for the Great Short Trade: The feel-good part of Obamanomics has people, investors, traders, pundits and politicians believing housing will bottom this year or early next. Maybe in 2012 - just do the math. Foreclosures are rising, so is unlisted and empty housing (as much many as 13 million units according to the New York Times), and recent Case-Shiller data shows the worst decline in housing prices ever with more to come. When Americans feel good about the value of their home and can get a home equity line, they spend money. When they can't, they don't spend as much - and in this recession, they do not and will not. And as consumer spending goes, so goes the economy. And within that economy, good bye to any growth or serious profits from direct beneficiaries of residential and commercial construction (more on that later) - think Sherwin Williams (SHW), Whirlpool (WHR), Louisiana Pacific (LPX), other suppliers.

Point Number Two: The housing bubble was really the tail end of a credit bubble that will last between a decade and a generation. Do I exaggerate? The nation's banks are on the way to pulling in two and a half trillion in credit lines via credit cards. Two thirds of people with a mortgage on their home had less than 15% equity in that home as of the end of last year, so at the rate the Case Shiller index is going, two thirds of all mortgage holders will have not equity in their homes by this time next year. Almost all increases in consumer spending were fueled by credit expansion since 2001 - remember, the cheerleader in chief did not ask for new taxes to pay for the war on terror, he told us to go shopping. That's leadership.

Point Number Three: The banks cannot lend more vigorously than they are, for the most part, based on real world accounting standards, broke and getting broker. For the next twelve quarters, at least, they will be carefully managing down existing toxic assets - anyone read anything about the PPIP program lately? - and using profits to offset write offs for these and newly made toxic assets. The new wave in toxicity will come from more mortgage meltdowns - worse than subprime according to many analysts - in the form of commercial property write downs. Did you know Wells Fargo (WFC) has almost $350 billion in commercial property loans? As for private equity disasters, ever hear of Chrysler? Well, Chrysler has many smaller cousins. And as some banks disappear, Uncle Sam will use funds to prop up the FDIC and the longer we keep the zombies in business, the more expensive this will be.

Point Number Four: The bottom line is corporate profits are going to take a hit. Stephanie Pomboy, credit and market analyst extraordinaire, in an interview with Barrons, spoke to the big rise in corporate profits since 2003-2003 as being directly linked to the radical expansion in consumer and other credit. Contracting credit means contracting profits.

And markets always regress, for some period of time, not just to the technical mean but to the mean of corporate earnings. Moderate analysts put S&P earnings this year at $55. This gives the market a current multiple of 18-20 - a multiple appropriate for a 3.5% plus growth economy. Plug in a recession multiple - 9 to 11 - and, well, you can do the math. Of course, I think corporate profits will be lower but even at $55 you get an S&P of 600 at best. Or a 33% decline from where are right now.

Bulls argue with interest rates so low there are no historical comparisons - the same bulls who use historical comparisons to support technical arguments. I guess we now know why bulls are called bulls.

So I, the great agnostic, believe the rally could last quite a while but the market cannot escape the economy and the economy cannot escape consumer spending and the banks and consumer spending and the banks cannot escape housing. And every time I make this argument I become persona non grata at yet another meeting or party.

Anything specific to short?

First, check out (and check the technicals and whether manic sentiment has left) the suppliers to new housing and remodeling - Whirlpool , Sherwin Williams - and some dodgy home builders like Toll (TOL) and KB (KBH).

Second, there are some banks still overvalued you can short. Take a look at Wells Fargo, selling at multiples well above the segment, has (or had at the end of last year) roughly $90 billion in option ARM mortgages and almost $350 billion in commercial property loans. And I still think Citigroup (C) will break itself up and shareholders could get the shaft.

Third, the ultimate consumer discretionary stocks - luxury and unnecessary; companies like Tiffany (TIF), Coach (COH), Harley Davidson (HOG). The last has just rolled over, and deserves special attention.

Last point - if you don't think housing will take at least two more years to bottom and want to write a comment - please do so - but please, prove your case. Mine is based on the dates mortgages were let, their dates for being re-set, which are in the middle of 2011, and given that defaults and foreclosures happen 3-6 months after re-sets, and then the foreclosed house hits the market - well, maybe it is 2013 after all.

Comments

[mderenthal:]

That's some scary stuff Michael, but nothing I can argue against. I'm a real estate broker in Florida and the one positive I can point to is an increase in investor activity and first time buyers, but they are almost exclusively buying on price right now which will continue to push values down, until the numbers improve to the point of enough buyers participating to start driving values back up. Good old fashion supply and demand... and demand in this sense isn't simply folks who need a place to live, but folks who need a place to live and who can find the money to purchase and who are gutsy enough to get back into the market right now - and there's not enough of that happening. Housing has a ways to go I fear.

May 28 10:07 AM

[jetmotoAG:]

Massive inflation is the only way out of setting new lows in the S&P and DOW. With bond yeilds rising, this seems unlikely however. But, imagine the FED monetizes to a degree that is impossible to comprehend. Think giving each houshold $50k. This money will be spent/used to payoff mortgages. The extra money sloshing around would support the debt loads, that would become lighter and lighter as time passes for commercial and residential alike. And in a high inflaitonary environment, equities are the place to be...there would be mass exodus of treasuries, munis, and corporate bonds with fixed rates. I DO NOT THINK THIS IS LIKELY, but is the only way your scenario is not played out...

May 28 10:22 AM

[johnmorrison9:]

I detect a worshipful admiration for the Liar in Chief.
I dare say he does not calm me, nor do I think they have
a game plan that beats go out and shop.
Time will tell, but I think the worse is yet to come.
Higher defaults, more taxes, and mafia style
Administration.

May 28 11:15 AM

[Misha:]

For whatever this worth, I will add another observation to Derenthal’s comments. I just closed on a refinance on my house with Countrywide (BAC now; I got 4.5% with one point; it would have been ~4.7-4.8% if I loch=ked last Friday and probably even higher today – check the rates). This is my 8th mortgage so I have some experience with this. For the first time ever, I was asked to bring a last week’s pay stub to the closing (they had my ~6 week old stub on file but are clearly concerned if I still have a job). For the first time ever, they actually generated 3 different appraisals of my house and asked me to pay for them upfront (my guess, too many houses appraise below what can be refinanced and they do not want to take a hit on cost of appraisals). At closing, I asked my mortgage broker, who manages the local Countrywide branch, about the business. The % of applications that actually proceed to closing was ~40% just a couple of months ago, and is ~60% now as they learned to better prescreen the applicants. On pending closings there are no move-up mortgages in a pipeline. All mortgages are either first time buyers (“They don’t know how lucky they are,” he said) or special situations. They have difficulty qualifying even good buyers. For example, they have a couple that sold their old house a couple of years ago and then spend some time renting and deciding where they want to move. They now want to buy here, sit on a ton of cash for a down payment, but my mortgage broker is concerned that with husband self employed (can use his for qualification!?), the wive’s income may not be enough to qualify. The day before my closing, he closed on a mortgage in a highly desirable, close to skiing brand new house that was originally listed for ~1.5M but was sold as bank owned for ~650K.

May 28 12:14 PM

[ain't no fo...:]

I agree with the author and the commenters about how bad things are, especially in housing. This is one of a few hundred "short" theme blogs I've read the past few weeks, and I find great agreement with most of them.

But you know what? For all the negativity, there is one thing on the other side of the short trade - and that is the unholy alliance of government and one or two monstrously large bank holding companies, which between them are pumping tens, perhaps hundreds of billions of taxpayer $$ into the market, and they are absolutely cleaning the shorts' clocks and taking no prisoners.

So fight the tape all we want, and I have here and there to a small extent, but all we are doing is fighting a very huge city hall, and until something changes, which I don't see happening, the guys with the biggest wallets are gonna win this game... news, common sense, reality and pursuasive arguments to the contrary be damned.

May 28 03:14 PM

[ain't no fo...:]

mafia? you're hilarious - pathetic, but hilarious.

Considering the nazi administration we just threw out, the one that destroyed our economy, our moral standing in the world, our Constitution, our military, our environment, basically every good thing this country ever stood for before dumbya, dickya and rove came riding into town, I'd say the Mafia looks pretty damn good right now.


On May 28 11:15 AM johnmorrison9 wrote:

> I detect a worshipful admiration for the Liar in Chief.
> I dare say he does not calm me, nor do I think they have
> a game plan that beats go out and shop.
> Time will tell, but I think the worse is yet to come.
> Higher defaults, more taxes, and mafia style
> Administration.

May 28 03:30 PM

[captainccs:]

The argument sounds familiar and rather convincing but there is a lot of money sitting on the sidelines (and under the mattress) and Bernanke has the printing press ready and well oiled so it's not a slam dunk that one or the other side will win.

May 28 05:12 PM

[JVan:]

I find myself in agreement with wpdragon. The shorts are in bad shape, and anyone who has traded awhile knows better than to fight the tape. With a bit of common sense about buying low and selling high within the support-resistance ranges of stocks that are in good uptrends, you should be able to make money in this market.

There are bears who write about everything that is the matter with the economy--and we learn a lot from them. But I never met an actual person who made money in the market without some optimism in reserve. There are enough green shoots sprouting these days to put me in that camp.

May 28 05:45 PM

[Fighting Yoda:]

"never met an actual person who made money in the market without some optimism in reserve." - well you can be an optimist on the short side too.

Well if you consider 500K+ job losses and 2%+ PM home price drops as green shoots - good luck to you.

We had a bubble stock market and a phony economy for last 20 years - ever since Greenspan. That era is over. Being long has not worked for the last 10 years. Time to rethink all investment strategies. There are no simple answers out there - long or short or long-short, biding time is my strategy for now - will wait for the euphoria to settle.


On May 28 05:45 PM JVan wrote:

> I find myself in agreement with wpdragon. The shorts are in bad shape,
> and anyone who has traded awhile knows better than to fight the tape.
> With a bit of common sense about buying low and selling high within
> the support-resistance ranges of stocks that are in good uptrends,
> you should be able to make money in this market.
>
> There are bears who write about everything that is the matter with
> the economy--and we learn a lot from them. But I never met an actual
> person who made money in the market without some optimism in reserve.
> There are enough green shoots sprouting these days to put me in that
> camp.

May 28 06:15 PM

[Stealthmouse:]

The bond market has a much bigger wallet then City Hall, and it's coming to the party now. The limitless funding mechanism is starting to get shut down. The administration will be unable to keep printing money and generating debt without the impact on dollar devaluation and inflation. If they stop, however, we will get the asset devaluation that comes with unwinding of leverage, which had already started but is being fought by the gubberment and its minions tooth and nail. Soon, those who need to pay for the consequences will, it's just a matter of when. The time is nigh, there isn't much room left for the PPT.


On May 28 03:14 PM wpdragon wrote:

> I agree with the author and the commenters about how bad things are,
> especially in housing. This is one of a few hundred "short" theme
> blogs I've read the past few weeks, and I find great agreement with
> most of them.
>
> But you know what? For all the negativity, there is one thing on
> the other side of the short trade - and that is the unholy alliance
> of government and one or two monstrously large bank holding companies,
> which between them are pumping tens, perhaps hundreds of billions
> of taxpayer $$ into the market, and they are absolutely cleaning
> the shorts' clocks and taking no prisoners.
>
> So fight the tape all we want, and I have here and there to a small
> extent, but all we are doing is fighting a very huge city hall, and
> until something changes, which I don't see happening, the guys with
> the biggest wallets are gonna win this game... news, common sense,
> reality and pursuasive arguments to the contrary be damned.

May 29 05:47 PM

[Stealthmouse:]

I doubled my net worth shorting last year and this one, so I'm not buying any green shoots. Have to be nimble though, or you'll be buried. The trend is still down. Oh, and I've been long on a few of the sucker rallies too. Fair is fair.


On May 28 06:15 PM Fighting Yoda wrote:

> "never met an actual person who made money in the market without
> some optimism in reserve." - well you can be an optimist on the short
> side too.
>
> Well if you consider 500K+ job losses and 2%+ PM home price drops
> as green shoots - good luck to you.
>
> We had a bubble stock market and a phony economy for last 20 years
> - ever since Greenspan. That era is over. Being long has not worked
> for the last 10 years. Time to rethink all investment strategies.
> There are no simple answers out there - long or short or long-short,
> biding time is my strategy for now - will wait for the euphoria to
> settle.

May 29 05:49 PM

[chamonix:]

Michael Shulman's ChangeWave Shorts did pretty well in 2008 and 2009 but since March, almost all his put positions are heavily under water. Heavily, 90% loss for many positions.

I am with him in his arguments and analysis but more importantly one has to listen to the market. Market is manipulated for sure and has been like this...It doesn't care whether you are mad at them or cal them irrational.

I am bearish at heart. This week I shorted COF, UPS, HOT, GT...I got in on one day and got out the next day when sensing market didn't want to go down...Left a Starbuck put posistion when I left 3:00 PM this Friday and was awed to learn the late minute rally put my puts deep in to water.

It is a coalition of world governments to pump up this market. Can we fight with them or argue with them?

May 30 03:01 PM

[Scott Croly:]

I cannot compete with the tactical, technical arithmetics regarding knowledge specifics at the beginning of this commentary; nevertheless, I have had some success long (+ 100% in the past 3 months on whole trading account equity). I did trade short last Fall (long puts (ITM) OEX Oct. exp., Fr, 9/26/2008, and 3 times thereafter; Forex long USD, short EUR 8/2008 - 9/2008 (obviously not now, short and medium term -- no mess in gov't run Forex now); called oil shorts 6/11/2008 shorts; back a ways: 1999, Dogs of the Dow, high dividend, low P/E value oriented stocks; sell We, 10/14/1987, and Mo, 10/19/1987 at market prior to opening buy back in within 1 and 2 weeks (not idle bravado, proved via tax returns and tickets, etc...). The trend is your frend implies context over text; textbook Finance 101 surely is the game of the past Supply Side Era, a dievestment [sic] of the past supposedly obsolete system. FYI, supply side is dead and stinkin' now itself... in general, on a sinusoid, alternate phase differentials are never consecutive! So if housing prices are not due for imminent increase (and newsflash, they are not, in a no-magic yuppie sinecure fantasy leverage environment) unless arbitrage complicity bangs USD to hell and the line serving demographic (try enlisted reserve personnel outside of Ft. Campbell, no jobs, and protecting overseas dumpers/protectionists for "free" trade, "free" markets (dievestment [sic] banker arbitrage differential) -- doubtful that you can pull that off anymore) is thrown out and outside interests buy and tourist on blown USD valuation (unit currency devaluation) a la Weimar redux (hyper inflation with extreme job loss, failed markets, dystopian aftermath), what do you think might be due for return in positive territory? (I have been long one of them, still with room to grow... what is the magic word in a real economy (not yuppie or Helens of Troy sinecure nominal market, and that word in context FORWARD), and what represents that in share symbols in the real market? I do agree with the author that TIF, COH are very tempting shorts; nevertheless, do not underestimate the nominal power of TARP fund baby bubblers... In such a macroeconomic lead as this current environment represents, better short-term tactical, technical trading ability is necessary than I have, but I see trends generally toward that about which I have just written (obviously look to similar cycles in the past -- also, bond yield curves give some general indication), and trends are the general tone forward anyway; one can NEVER precisely predict y over x!. And to WPdragon: EXCELLENT comment!!! (And to johnmorrison9: .._. .._) It happened on their watch; step up and take personal responsibility. (Well, I guess that's just a preach on everyone else, obviously not their practice). I come from a line serving, in-zone over 4 generations family with MIT, Johns Hopkins, Columbia College in our background; ie, we have context. The former public sector VCEO 5 time draft dodger, Mr. "I had other priorities," waving his Made in Taiwan American flag from his vicarious warrior armchair while fronting swiftboaters on everyone else (I do respect their UCMJ service, but deplore their under-the-table paid for civilian negative behavior) represents hyper-subversive, anti-American dystopia. Hey bud, take a 200 million Earth retro-orbit ride back to the Jurassic period where you belong; better yet, trip on over to the crocodile pit...

Jun 03 08:35 AM

[The Fox:]

Scott Croly,

Get over yourself. I haven't read a more "holier than thou" post in some time. MIT, Columbia...how gives a shit. That and a few bucks will get you a cup of coffee. The fact is that you don't know any better what is happening...or going to happen... then anyone else. Our socialistic government is at the wheel so all bets are off. We are, and will continue to be, in uncharted waters. I think I can comfortably say that "This all ends bad". When...how knows.

Jun 06 08:25 AM

[Theta Guy:]

The case you make is a good one Michael but light on details on your specific short choices (entry points specifically). As this market proves time and time again, overvalued equities can remain overvalued for a very long time. The idea that a stock SHOULD come down doesn't make it happen. While most of these stocks could be good short candidates, the question is: At what price?

Jul 11 03:50 PM