What are the best shorts in this flailing market? Depends on whether you do charts or fundamentals. I do fundamentals with a light taste of charts, so this is about fundamentally weak companies that can no longer benefit from tailwinds provided by a technically driven market rally.
Where to look? First, unduly high Wall Street expectations for fundamentals. Second, companies in segments that are going to take a hit when the economy takes its double dip or has meager growth in the second half of the year. Third, companies with weak balance sheets. Fourth, companies inside bubbles about to pop, or ETFs for segments that are bubblicious and ready to blow for any number of reasons.
Undue Street Expectations: The Street is overly fond of the banks. Yes, the stocks are flat or have dipped for the past three months but Wall Street profit estimates - and target prices - are out of line with reality. Not to mention $1.5 trillion in toxic assets seem to have been forgotten. I agree with uber analyst Meredith Whitney; I have since she turned me onto the problems with the big banks in the green room at Fox Business in the fall of 2007. that bank profits will disappoint in the second half of the year due to economic stagnation, increasing consumer credit defaults, increasing foreclosures. One analyst sees up to seven million in the next 30 months, mostly from prime borrowers, and decreased trading profits.
Over the past few days earnings announcements - notably Citigroup's (C) and Capital One's (COF) - made it clear the banks are again managing quarterly earnings instead of doing whatever they can to shore up balance sheets. Both reserved less than they had in the past yet also expressed serious concern about the quality of consumer credit throughout the year. Wells Fargo (WFC) also did not reserve as much as it should have given the rapidly deteriorating quality of its commercial real estate portfolio.
My concerns are independent of the factors that have hit bank stocks recently - potential new fees ($90 billion) and tough regulations that will restrict leverage, the scope and operations and certain profitable activities such as proprietary trading. Banks are also being forced to take some of their off balance sheet assets and put them on the balance sheet. Wells has to do this with more than $100 billion in assets. Don't cringe just yet, they have more than another trillion, with a T, off balance sheet. Capital One surprised itself and analysts by the amount of off balance sheet assets they needed to put on.
One last wrinkle - and this will hit Bank of America (BAC), purchaser of Countrywide Financial, and Wells Fargo, purchaser of Wachovia which had purchased Golden West - that comes from Freddie Mac (FRE) and Fannie Mae (FNM). They are now gong through the documentation of mortgages that have fallen into default, and forcing banks to repurchase these mortgages. Freddie Mac hit banks for $2.7 billion in the first nine months of 2009, Fannie Mae $4.3 billion. This is gong to accelerate the next eight to twelve quarters, a big drain on earnings.
The Impact of a Double Dip/Low Growth Second Half: Retailers and many consumer discretionary stocks outperformed the market last year, and are still seen by some as holding great value. Sure, right. Consumer spending from 2000-2008 was driven almost 100% by expanding credit. Incomes were flat, spending went up, and a couple of trillion of spending power came from credit cards and home equity loans. We now have declining national income, not to mention declining household spending, and trillions in credit lines have been pulled back. Without job growth - big time job growth that lifts national income - the consumer will not be back enough to justify current valuations.
The key here is not the statistic always bandied about - the unemployment rate - but the actual number of people working multiplied by their average wages in a week. This, plus interest income and some other items, constitute national income. You may read the country lost 450,00 jobs and the blow-dried pundits now paid to be smiling and optimistic will say that is lot better than six months ago. True. But the real number that impacts national income and spending is that number plus the number of people dropping out of the work force. When you put these numbers together you have more than thirteen million people not working who were working a couple of years back. And that is a lot of lost spending power.
While many turn to the retailers as the biggest potential victims, sorry folks, it is the high end adult toy makers. No jokes please. I mean boats and motorcycles and spas and high end clothing. That means companies like Brunswick (BC), Harley Davidson (HOG), Steiner Leisure (STNR), Liz Claiborne (LIZ) and Saks (SKS). And in 2011, many of the people who typically buy products from these companies face higher taxes. The weak balance sheets here...oh, I am getting ahead of myself.
Weak Balance Sheets: There are some frightening balance sheets out there, and companies yet to issue new shares, roll over debt and still in need of a lot of financing are facing major problems in 2010. Morningstar put out a list of "low cushion cash flow" stocks based on debt, cashflow and the need to refinance soon. The leader on their board with a B- credit rating is Royal Caribbean (RCL) - and no one needs to take a cruise, do they?
Finding weak balance sheets is easy; matching that problem with creditor reluctance to provide new financing and weak cashflow is the next step. You can find a whole slew of these weaklings among the home builders. These dogs have been held up by unconscionable federal tax rebates - multiple billions over the past three years - and the days of this largesse is over. Arguably the company in the worst shape is Hovnanian (HOV) for they also concentrate on high end homes that can be built but are not selling due to a lack of demand and virtually no jumbo mortgages to be had.
Lennar (LEN) also has a scary balance sheet.
Retailers, in general, are very tightly managed and have great flexibility in reducing costs through inventory and staff reductions. That being said, Macy's (M) balance sheet is almost surreal given its cashflow, and Macy's is at the top end of the full purpose department store segment, a weak segment at the best of times.
Bubblicious Companies: This is easy. China is one big asset bubble driven by state banks lending as fast and as furious as possible, building unwanted condos, unneeded steel mills and so on. Where to start? ETFs that track the domestic companies, not the exporters - the most liquid is the PGJ - and the entire segment of Chinese solar companies such as LDK Solar (LDK) or First Solar (FSLR). They are all overvalued. Who knows that they are really selling versus booking versus shipping, and the renewable energy bubble is, well, a bubble. Combine a China bubble with a renewable energy bubble and you get double bubblicious.