Where To Short When You Short This Market

by: Vince Martin

After a decline of over one percent in the broad market as of this writing Wednesday, the 2012 bull run for US equities is beginning to show signs of weakness. With major media outlets such as Reuters and CNBC looking for a pullback after the S&P 500 rose 12% in the first quarter, and volatility rising, many investors feel the market is overheated, and correction around the corner.

For those investors willing to bet that the rally has run out of steam, there are a few specific sectors worth shorting. These sectors look to have downside potential that exceeds the market if fear returns and economic worries in Europe, China, and the US take their toll on equities:

Semiconductors: The Philadelphia Semiconductor Index (SOX) is up nearly 19% year-to-date, despite a 2.7% drop by midday Wednesday led by a missed earnings report at SanDisk (SNDK). And while I was bullish on chips last year, the increase in valuation (the SOX is still up over 30% from October lows) and the seemingly universal declaration that the "bottom" has been reached in the industry make the sector a ripe contrarian play.

One of the best short candidates in the sector is Cirrus Logic (CRUS). I recommended a pairs trade with Apple (AAPL) -- long AAPL, short CRUS -- back in December. CRUS has risen 40% since then, an impressive move that still trails Apple's 60% gain over the four-month span. Now CRUS, which trades at 20 times earnings even when backing out the company's net cash, appears ripe for a naked short. With analysts now applying targets to AAPL simply for the publicity, it looks like the Apple run may be nearing its peak. Shorting a supplier who relies on the company for nearly 60% of revenue, and whose growth does not seem to support such a high multiple is a safer -- and still potentially more lucrative -- play then trying to time the bull run of what is likely the market's most popular and well-covered stock right now

Another candidate in the sector include Synopsys (SNPS), which has hit a multiple top around 31 after an almost uninterrupted eight-month bull run. The company is valued at over 15 times trailing non-GAAP earnings, despite projections that the company's relatively slow growth rate will continue. If 2013-14 earnings estimates begin to see downward revisions, the stock, trading at a multiple above most of its peers (even giants such as Intel (INTC) and Broadcom (BRCM)) will take a hit. The sector can also be shorted through ETFs SMH, XSD, and PSI.

US-Facing Casino Operators: Valuations in the sector are historically tied to economic sentiment, and the first quarter of 2012 was no different, as the Market Vectors Gaming ETF (BJK) rose 16% in the first quarter. The continuing strength in the Macau gambling market -- which is now five times the size of the Las Vegas Strip in net gambling revenue -- was part of the story. But US casinos have done as well.

One of the big winners -- and the best short -- is Isle of Capri (ISLE). The company operates 13 regional properties in the US, but faces a series of headwinds. It has over $1 billion in net debt, compared to a market capitalization of $277 million. As I noted in a detailed piece for CalvinAyre.com last month, 35% of the company's net revenue -- gaming revenue less promotional allowances -- goes to interest payments and gambling taxes. The company earned an impressive $65 million in free cash in fiscal 2011 (ending April) -- yet paid $90 million in interest alone on its debt balance. Revenue growth has been relatively non-existent, and the recent sale of one of its (admittedly underperforming) properties for just $45 million casts further doubt on the company's valuation. High-debt, low-growth, high-risk stocks are exactly the type to see heavy short action when fear and volatility return to the market; yet ISLE has a short float below 5%, despite a 52% gain year-to-date.

Pinnacle Entertainment (PNK) is another regional operator with a heavy debt load; long-term debt is nearly 2.4 times equity. Interest payments at PNK are also in the $90 million range, versus just $132 million in operating cash flow in 2011. The bull case for PNK assumes that when its recent run of developments end, the company will be able to deleverage and pay down debt; but the legacy properties are not generating enough cash to make that likely. Like ISLE, PNK faces cannibalization as gambling is legalized in new markets, and competition at its existing properties. PNK has shown some better revenue growth through expansion, but its balance sheet will become an issue should the market turn.

Housing Stocks: The downturn in the sector has already begun, led by disappointing earnings at KB Home (KBH) and a 7% drop in new home sales since December. Yet Lennar (LEN) is still up 36% year-to-date, and trading at 20 times its forward earnings. Hovnanian Enterprises (HOV) more than doubled in the year's first six weeks, before turning south amid bad industry news and Tuesday's dilutive equity offering. HOV has a negative book value and sharply negative earnings projections through 2013. It is still up 63% year-to-date, and remains one of the market's most heavily shorted stocks.

Two large-cap stocks worth a look for shorts are Home Depot (HD) and Lowe's (LOW). Both stocks are within a whisker of their 52-week highs, despite the still-dormant housing market and middling consumer confidence. As we head into a key season for home improvement purchases, any weakness in sales reports could hurt the stock; and with the stocks trading at 15 (NYSE:HD) and 14 (NYSE:LOW) times 2013 earnings, most of the good news appears priced in.

Shorting sector funds or individual stocks in any of these industries, as opposed to simply shorting the broad market through ETFs, looks to be a more aggressive -- and, yes, more risky -- way to time what appears to be an overpriced market. The constant talk of correction is usually seen as a contrarian view that there is another brick in the "wall of worry" equities like to climb. But with the Fed re-emphasizing its opposition to QE3, Europe "a little too quiet," and fears of a hard landing in China still present, it won't take much for a 10-15% correction in the broad market. Such a correction will likely be amplified in semis, housing, and gambling -- sectors that saw outsized gains on the way up.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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