As we saw last week, the market appears to be in the process of topping out. With the stock market more than doubling over the past two years since the great financial crisis lows, it is no surprise that the market may be hitting its peak. Between the U.S.' dismal GDP report, the unending black clouds lingering over Europe, and the signs that emerging markets are slowing down, we face the prospect that the stock market's run is over. The market’s increasingly choppy volatile trade is a textbook indicator that the market has exhausted its supply of bullish energy and is likely to go lower this fall.
However, we certainly are not at a so-called "short the phone book" moment yet. Looking back to 2007, we find that weak stocks started plummeting a good six to nine months before the rest of the market finally caved in. A determined short-seller who waited patiently for the market to collapse would eventually make money shorting anything; even the famed Four Horsemen of technology - Research In Motion (RIMM), Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), and Google (NASDAQ:GOOG) - finally acquiesced to market weakness and nosedived in late 2008. But a smarter short-seller had already been minting money for a year at that point, as the shares of weak companies had been in inexorable decline for a full year at that point. Those who had been betting against vulnerable financials, homebuilders, insurers, and other assorted weak companies made far more than short-sellers who only bet against the market generally.
The key thing to keep in mind is that different parts of the market will fall apart more quickly than others during the initial phase of a new bear market. The key to finding good short positions during the initial phase of a bear market is to find a sector that is already under fire, and then find the worst dogs within the sector. Why go through the hassle of trying to be a hero and shorting the exact top in wild momentum stocks like Netflix (NASDAQ:NFLX) or Chipotle (NYSE:CMG) when you can short stocks that are already declining and are quite possibly heading to zero?
As I repeatedly say, there is no valor in shorting stocks making new highs, and no one gives you a medal for shorting the exact top of a ridiculously pumped stock like, say, Lululemon (NASDAQ:LULU). Although shorting these names will eventually produce good returns (and good stories for cocktail parties), while the general market is just starting to crack, your short positions should be more targeted. Here is my list of fourteen high conviction short ideas for a market on the verge of a significant breakdown. These suggestions span a variety of sectors, market caps, and geographic locations, offering a diversified pool of good short candidates.
Bank Of America (NYSE:BAC)
America's largest bank remains among the country's most vulnerable. The bank lost almost ten billion dollars in its most recent quarter, and skeptics are increasingly suspecting that the company will have to raise more capital. With legal costs rising, and two questionable mergers (Countrywide and Merrill Lynch) still causing headaches, Bank of America is likely to retain its unenviable position as the US financial sector's "black sheep."
With the bank already facing mounting troubles from its growing inventory of foreclosed houses, (some of which are now being demolished – talk about a worthless asset!) it is hard to see investors treating Bank of America well when the market rolls over again. For bears who enjoyed the fun of shorting Countrywide Financial during the financial crisis, the fun can be repeated: A short position on its new owner, Bank of America, should produce similarly pleasing results in the coming months.
Ancestry.com has been one of the more ridiculous beneficiaries of the latest internet bubble. In a classic example of how analysts can get hopelessly confused when an entire sector enters fantasy-land valuations, Ancestry.com has been labeled as a "value play" within the internet sector. Even after last week's drubbing following Ancestry.com's unexpectedly poor second-quarter results, the company still trades at an alarming 42 times earnings.
If you think that is a value, then clearly you didn't pay close attention when reading value-investing works by the likes of Benjamin Graham or Warren Buffett. What went wrong here is that analysts covering the internet space who rightly shied away from recommending overpriced momentum names such as Travelzoo (NASDAQ:TZOO) or LinkedIn (NYSE:LNKD) felt compelled to be optimistic about something. Thus, they ended up recommending second-tier niche internet plays such as Ancestry.com that had the comparatively lowest valuations within the sector.
However, as the internet bubble starts to deflate, the weakest names within the sector should fall the fastest. The decline began at ACOM last week, as the stock dumped more than ten percent following bad second-quarter results. With the company having only $2/share in cash and $8/share in book value, it is hard to justify anything close to the current $35 price. Unlike many web properties with subscription models, it is hard to see why Ancestry.com's customers would maintain their subscriptions for long.
People's taste in music, for example, changes frequently thus supporting Pandora's (NYSE:P) subscription model – even if consumers buy the music they like, they will still want to discover fresh new music, and as such, maintain their Pandora subscriptions. However, it is hard to see why people will remain customers of Ancestry.com for long, given that people's ancestries are pretty much set in stone. Already, the company's rising churn rate is starting to show the weakness of the underlying business model. While the company can likely maintain a stable profitable business, the website's niche is simply not a growth industry. People are paying mainstream internet growth stock prices for a highly-niche web site with a very low revenue ceiling. As the internet bubble deflates in coming months, the weakest players within the sector, such as Ancestry.com, should fall most quickly.
See Part 2 »
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.