Three Vulnerable Stocks for the Sharp Pullback Ahead

As we enter the last week of the quarter, domestic stock markets are having a nice year despite the slight pullback thus far this month.

Investors haven’t really had to make big decisions about market capitalization or style thus far in order to exceed cash returns handily. As measured by the Russell 1000 and the Russell 2000, Growth has trumped Value while Large-Caps have narrowly beaten Small-Caps. The S&P indices show a slightly different picture, as the S&P 600 is ahead of the S&P 500. The answer lies in the fact that the real strength in the market has been in the “just below Large-Cap” space. Interesting as well is the divergence within the style returns, as Growth is beating Value according to the S&P 600 but not in the S&P 500. No matter how one looks at it, though, equity investors should be a pretty happy lot.

While I am no Chicken Little, I do believe that we are about to experience a sharp pullback. I understand that many a pundit has been tripping on such predictions for quite some time. If they were lucky enough to have called it right in February, I promise that these guys certainly weren’t able to get bullish after the steep but brief drop. I actually was fortunate to have gotten that one right, stating in early March that the correction was already over. In fact, I included a list of 25 stocks worth investigating at that time.

From the close on 3/8 to the close on 6/22, the list increased an average of 16.3% and a median of 9.9% (compared to a 7% increase in the S&P 500 and a 6.3% increase in the Russell 2000). That list was generated using StockVal, and the reader can refer back to the original article for the parameters. Interestingly, Stride-Rite (SRR) and Oakley (OO) were acquired subsequent to that article, each helping to boost the average. The big winners, though, were Crocs (CROX), Force Protection (FRPT) and LoopNet (LOOP).

I started becoming bearish at the very end of May, so June has been testing my patience to some degree. I suppose the primary driver of my negativity at the time was the creeping Treasury yields. Some of the other factors that I thought might conspire to hurt the market were the upcoming Apple (AAPL) iPhone release (buy the rumor, sell the news reaction), the surprising miss by Network Appliance (NTAP) filtering through other companies and the fact that the markets had gotten short-term overbought. Well, the subsequent interest-rate rise seems to be at least somewhat incorporated into the market now, and the price action of the month thus far has somewhat corrected the overbought condition of the market. So, why am I so negative, at least in the short-run?

I think, as I have all year, that the market will remain in a tug-of-war between fears of excessive growth and fears of housing-induced slowdown. Clearly, the global economic strength, which is leading other monetary authorities to tighten their domestic policies, is a great thing for many companies here. Thankfully, we have a significant component of our economy dragging down overall growth and permitting the economic expansion to persist much longer than typically has been the case.

The pendulum is swinging towards the recession-fear camp, and they would cite a handcuffed Fed that should be lowering rates to stave off the coming depression for the U.S. Consumer. I tend to think that we are in a period now where the headlines will increasingly highlight this risk. Since the NTAP miss in late May, we have seen otherr demand-related misses in Technology, Microchip (MCHP) and retailers like Best Buy (BBY) and Circuit City (CC). We are also now starting to see a lot of pain in the financial world. While at this point it sure seems to be underreported, the news on Friday that Brookstreet Securities had immediately shut down operations and laid off 600+ brokers due to its capital being wiped out on a margin call related to mortgage debt jumps out at me as a sign of how ordinary people (not the borrowers that are in over their head but the lenders now too) are being impacted. My bear thesis isn’t so bearish.

So many have been positioning for a pullback that hasn’t materialized, and I think that it finally will. I don’t know how bad it might be, but I expect that QQQQ, which closed at 47.33 after making a divergent high of close to 48 on Thursday, should pull back to 45.50 or so. It could be worse than that, though. I wouldn’t expect that the 44 level will be violated. Is this a tremendous move? No. Can traders make money on their shorts (and investors save money by deferring buys)? Yes. The move is consistent with the 10dma pulling back to the rising 200dma for all the major indices (which didn’t happen on the pullback in late February).

I am not spending a lot of time looking for shorts. Personally, I am short via some ETFs as well as Network Appliances. Reviewing the 100 stocks I follow most closely, here are some ideas from the Tech sector (which I find particularly vulnerable), including rationales, triggers and objectives:

These three stocks are quite different, as Jabil (JBL) is in an extended decline already, NTAP has recently rolled over and MEMC (WFR) appears to be topping. WFR, in particular, is interesting to me as I believe that the margins are unsustainably high – don’t get fooled by the “low” PE.

Disclosure: Short NTAP

Comments

[NutritionFacts:]

Thanks for this piece, but your argument is not particularly compelling. I remain unconvinced, since the 'Goldilocks' phonomenon that arguably has allowed the bull to keep on stomping is, by your own admission, still alive (to whit, "the market will remain in a tug-of-war between fears of excessive growth and fears of housing-induced slowdown"). Not too hot, not too cold? Aah, just right.

I hope.

2007 Jun 25 06:51 PM

[Alan Brochs...:]

The Goldilocks scenario and mine aren't mutually exclusive. There are zigs and zags along the path to Grandma's (whoops, wrong fable). I didn't include all of the points that I had intended to make regarding a short-term pullback. The one I regret not mentioning is some technical weakness in the megacaps that I think is an early reflection of diminishing liquidity. The divergence that I did mention I probably should have explained better. The strength in the semis last week and in tech generally was rotational and disguised the underlying weakness in the broader market. A final point is that it has been a heckuva first half, and I expect to see some profit-taking this week and also next week.

2007 Jun 25 10:15 PM

[NutritionFacts:]

Okay Alan. I think the problem is that you stated in the piece that you were expecting a sharp pullback, whereas in your comments you state that you expect some profit-taking. Let's not quibble though. Things are going to plan right now.

2007 Jul 02 03:10 PM