As for the S&P 500, the lowest-cost way to short it would be to sell short SPY, the S&P 500 ETF. If you’d rather use options to short the S&P, you can buy “at the money” or slightly out of the money puts on SPY. I’d stick to further expiration dates.
 
The S&P 500 is overvalued. It would take a resumption of investor fear to drive it down to, or below intrinsic value. Despite recent weakness, we’re not yet seeing much fear — at least not as much fear as we should be seeing, considering the horrible economic and regulatory environment. The vast majority of investors still think we’re in a new bull market.
 
The best estimates I’ve seen put the S&P 500’s intrinsic value somewhere in the range of 800 to 900. This range should go up over time assuming economic growth, and the “survivorship bias” of the index (i.e., companies like GM and Citigroup, whose market caps get obliterated, get lower weights, while successful companies like Apple get higher weights as they rally).
 
But for now, considering valuations, profit margins, and risk premiums, the S&P is likely overvalued by 25%. The S&P could easily fall to that range by 2010, 2011, or 2012 but there’s no way of knowing when.
 
2. Can I buy and sell put options from my online brokerage account, or do I need to use a broker?
 
Dan: Every good online brokerage offers options trading. You’ll just need to open a margin account. Your online broker should have all of the available educational tools. E*TRADE has worthwhile links to free educational resources on options trading here. The basics of the simplest options trades are not complicated. I like to keep recommendations simple.
 
3. Is there a minimum amount of money a person needs to short stocks?
 
Dan: From my experience, there is no minimum amount. Most likely, the minimum amount would be your broker’s minimum for opening a margin account. You need a margin account to sell short. Another way to limit the amount of money you commit to shorting would be to buy put options instead. You can get the same exposure as shorting, but with much less money involved. Each put contract gives you exposure to a short sale of 100 shares of stock.
 
For example, if you shorted 100 shares of a $20 stock, you’d have to borrow $2,000 from your broker in your margin account (the amount borrowed depends on your level of equity in your margin account), sell the stock at $20, and have the obligation to buy it back in the future. Your profit is the difference in the stock price between when you sell it short and buy it back, multiplied by the amount of shares you sold short.
 
If you used a put option with an asking price of $2 per contract, you can short the same value of shares ($2,000), but only risk $200 ($2 per contract times the right to sell 100 shares of the underlying stock). Profit potential is much higher, but so is the risk of loss. The way we deal with this in Strategic Short Report is to find stocks that we’re highly confident are overvalued, and look for put options with high strike prices and distant expiration dates. If the thesis isn’t developing as we expected after a few months, we cut our losses.

4. Is there still opportunity to short BP, what do you think is the best way to do this?
 
Dan: I would not recommend shorting BP at today’s price, because it’s likely undervalued. The only thing powerful enough to drive it much lower would be endless class action lawsuits, without any sort of negotiated cap on damages.
 
That’s not an outcome I would bet on. It’s certainly possible, but not likely. The U.S. government has an interest in keeping BP alive and functioning normally, so it can fund cleanup costs damage claims out of its future cash flow. The value of BP’s future cash flows — after adjusting for spill-related costs — is likely much higher than the current stock price (especially if over the next decade, average oil prices are north of $100 per barrel, which is very possible).
 
That being said, if you want to bet on the government and lawyers tearing the company apart in a foolhardy manner (which wouldn’t necessarily surprise me), it would be much smarter to buy puts rather than sell the stock short, because with puts, you can limit your risk of losses.

Regards,
Dan Amoss
Whiskey & Gunpowder

June 17, 2010

How to Short the Market Right Now was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Dan Amoss: Okay, well I start from the assumption that most economists and analysts are ignoring the importance of balance sheets. There’s way too much bad debt in the global economy, and governments and central banks are trying to paper over these bad debts.

And the consequence of this is that governments will eventually reach the limits of what the market will allow in terms of debt to GDP ratios. At that point, it will be hard for the economy to both grow and service the incredible burden of debt that it has.

Overindebted balance sheets at all levels of society tells me that this is not a typical economic cycle. Yet the stock market is priced for a typical economic cycle, and factoring in record earnings and profit margins in 2011 and 2012.

Stocks are expensive right now, based on my favorite method of valuing the broad stock indices, which is the Shiller PE ratio, the work of Yale economist Robert Shiller. This PE ratio is defined as the price of the S&P 500 divided by the average, inflation-adjusted earnings over the past 10 years. This ratio is about 20 right now, far above the historical average of about 15.

At the end of long bear markets, the Shiller PE shrinks to between five and ten. So over the next few years, the broad market could go down another 50% through some combination of falling prices and rising corporate earnings.

Most stocks are likely to fall this summer, simply because efforts of governments and central banks to paper over bad debts will hit some serious roadblocks, particularly in Europe and in the U.S. mortgage market. Any company that needs to constantly tap the corporate bond market or its line of credit could see much more weakness this summer.

I’m always looking for stocks that can fall faster than the market. Typically, I like to drill down to specific sectors and stocks to find the ones that are the weakest and/or the most expensive.

Gary: Could you give a couple examples of that?

Dan: Sure, an example of an area that I’ve been focusing on is companies exposed to commercial real estate — that includes most REITs. REITs trade like stocks, and they own portfolios of commercial real estate. They typically pay out 90% of their earnings as cash dividends. REITs reached an extraordinarily high valuation in 2007. They were priced for for continued increases in rents as far as the eye could see. And people were using extraordinary amounts of leverage to buy these properties.

And then when the 2008 crisis hit and financing dried up, you saw affordability collapse, in terms of what types of properties investors could buy on a leveraged basis.

Since the 2008 panic, the Fed pulling rates down to zero percent has helped REITs out a lot, but now you have a big overhang of what I call zombie properties that will restrain the appraised value of the overall index of commercial real estate.

Gary: Now, in terms of the feds holding down interest rates, you expect this will result in bigger problems?

Dan: Well, it delays the ultimate resolution of the commercial real estate bubble that peaked in 2007. What the market needs to restore health to commercial real estate is fresh equity. Which means you need liquidations of the old owners’ interest in kicking hte can down the road with serial refinancings, have their equity wiped out, and bring in new buyers with the capacity to inject sustainable levels of equity into these properties.

For most commerical properties purchased with high leverage between 2005 and 2007, the debt to asset ratios — if they haven’t been foreclosed on — are now well over a hundred percent. In other words, the investors are underwater, like a homeowner with negative equity. Owners with negative equity have little incentive to properly maintain their properties. Properties that aren’t maintained, lose many tenants as leases roll off, which accelerates a liquidity crisis. In this type of situation, which is rampant, if the banks don’t foreclose early on, and just roll over loans to insolvent borrowers, the ultimate loan charge-offs when forclosure becomes inevitable will be even larger.

So going back to the zero percent effect: for banks, the lower interest rates are, the lower they can justify on their income statements how long they can hold these non-cash flowing properties.

Gary: I see, and another example if you have one handy?

Dan: Yeah, another area I’m focusing on is the consumer electronics companies that produce in the U.S. and export to Europe. One in particular generated most of its 2009 operating earnings in Europe.

This company is heavily exposed to the Euro/dollar exchange rate. Its stock doubled off the lows in 2009, yet the company is facing massive long-term head winds in their core product. Technological shifts will make it obsolete in a decade.

Yet the market is pricing this stock like we’re in a typical economic recovery and it won’t be hit by competitive pricing pressures and a weak European economy.

Gary: This is not your garden variety contraction; it’s not just a regular recession. But before I move on, two things I figure would be hit a lot by the lack of credit were things homes and like electronic toys seem to be the biggest beneficiaries of cheap credit when it was available for the past, I don’t know how many years. Does that sound right to you?

Dan: Yeah, that sounds right. Easy credit can impact the economy in a lot of destructive ways by sending all sorts of false signals about what sustainable demand really is to producers.

Producers gear up equipment to service that demand, and then when the credit’s gone, the pain, the adjustment is wrenching. We see this now, not only in the U.S. consumer economy.

There’s risk of German factories selling into Southern Europe. There’s risk of a big adjustment there, loss of sales and margins. And same thing with China and the U.S. relationship, balances in the global economy will take a long time to work out.

There will be a lot of wealth destroyed in the process.

Gary: Speaking of wealth being destroyed, what effects do you see coming out of the deepwater drilling moratorium for the Gulf of Mexico? The people in government who are instituting it, they probably don’t think about these things at all — about perverse and unintended outcomes.

Dan: Yeah, there’s no doubt that this is a huge environmental catastrophe, but it seems like government regulators are trying to make this even worse.

Whereas the fishing and tourism industry was hurt by the first order effects of the spill, by imposing this six month blanket moratorium on the rest of the off shore drilling industry, we’re going to start seeing rapid production decline rates kick in on a lot of these off shore wells.

We get in excess of one million barrels of oil per day of oil production in the U.S. from deep water wells. The nature of these wells, the decline rates of these wells, dictates that you’ve got to keep drilling new prospects very actively to avoid a scenario of contracting oil production in the Gulf.

A report from Morgan Stanley that came out last week claimed that in an extreme worst case scenario — if deepwater drilling is permanently banned in the Gulf of Mexico, it will drive today’s 1.2 million barrels of oil per day of deep water oil production down to zero over a four to five year period.

And considering the state of big oil projects around the world and the ever growing demand from emerging economies, we simply can’t afford that level of decline in production. You can have a situation a couple of years from now where high oil prices will continue to crowd out any discretionary spending among U.S. consumers, which would be very bad for a lot of stocks.

Gary: So it’s going to pinch the consumer’s wallet and we’re talking everything being affected.

Dan: Exactly. The average American household spends anywhere between five to ten percent of their income on gasoline and transportation. That can easily go much higher. In developing nations, the cost of transporatation is a much higher percentage of the household budget, yet demand’s still growing.

Gary: That sounds like a recipe for disaster. So you have the government claiming it’s going to stimulate the economy, which is probably not a good idea in the first place; and then they’re doing this, which will create a huge drag on the economy. For stocks, it’s just sounding pretty bad.

Dan: Exactly.

Gary: Speaking of government intervention — I want to talk about short selling, which government tries to portray as evil, as this destructive, unpatriotic act, but don’t short sellers serve an important function, especially now they’re going to have as you mentioned this summer coming up, looks like they’re going to have just a field day? They do something important for the market.

Dan: The most important thing that short sellers do is they communicate, especially during the midst of bubbles, when the emperor has no clothes. They point out inefficiencies in pricing. Famous short sellers were among the first to warn about credit excess a few years ago and housing bubble.

Short sellers basically sell into the peaks of bubbles and provide liquidity to panicky sellers near market bottoms when they buy to cover short positions. When people are panicked and wanted to get out, and there are few providers of liquidity, they’re one of the few consistent providers of liquidity in really weak markets.

And secondly I would say based upon history, mostly because the tide tends to go against short sellers over the long term, they have to be twice as rigorous in their analysis. You can’t afford to be wrong as often when you’re a short seller, especially when you’re betting against a company using accounting shenanigans to inflate their earnings.

So those are two main reasons that short selling benefits the market. There are several more, but those are the first two that come to mind.

Gary: Sounds like short sellers have to be very smart. So what kinds of things would happen — there was a ban on it for a little while, kind of a populist thing to demonize short selling.

What happens when there aren’t short sellers? They provide this important function; say they’re stopped from doing it, which I guess could happen, again.

Dan: The last few instances where they’ve banned short selling led to a period when markets typically went into free fall, and we saw that in the fall of 2008 in the U.S. with the ban on shorting financial stocks.

The biggest period of decline occurred after the bans. And the reason that is, is because so many market participants, everyone from long/short hedge funds to convertible bond investors, use short selling as a key component of their investment strategy.

So when you take that component away, those investors typically just withdraw from the market. And when you have a mass amount of investors who tend to be very active traders withdrawing from the market, liquidity evaporates. And the last time you want liquidity to evaporate is during a panicked period.

It tends to make things much worse and has never resulted in the outcomes that the bureaucrats and regulators are seeking by banning short selling.

Gary: Imagine that.

Dan: They think it will end selling, but what really causes markets to crash is no bidding. Banning short selling often results in a market with no bids.

Gary: Would you say that’s fair to say that markets tend not to get so out of whack when they are allowed to correct themselves automatically as opposed to having things but in their way that are very un-market like…basically politics and political decisions?

Dan: Yes.

Gary: Okay, so the short sellers fit right in the Whiskey Bar really easily. Do you have any famous stories or examples of short selling?

Dan: The best example in my mind of how short sellers provide value to investors and society at large is the story of Jim Chanos and Enron. Enron was a darling stock in the late 90s and up until the year 2000. Every analyst on Wall Street loved it; brokers were pushing it to their clients.

You have this hedge fund maanger dedicated soloey to short selling, Jim Chanos, who’s known for his skill in forensic accounting. He looked into all the off-balance sheet entities, figures out what’s really going on, and concluded that the company was basically a big Ponzi basically. So his hedge fund sold short the stock.

Chanos was selling near the peak as the public was buying; if Chanos’ fund hadn’t shorted it so aggressively, the stock likely would have kept going up because it had the nature of a Ponzi where because it was going up, it was drawing in more capital, which in turn cause it to go up even further. And because Chanos was selling short , he stopped a lot of investors from losing even more money by prompting them to dig deeper and ask harder questions in order to really understand a company that was ‘all hat and no cattle.’

Gary: He corrected an imbalance. He was the market that worked, essentially. Regulators say they need to be there to prevent Ponzi schmes and things that’s rob the investor, but he was doing their job.

Dan: If regulators want better enforcement of the security laws, they should do everything to listen to, rather than hamper short sellers, especially in situations where ridiculously promotional companies are constantly in the market raising capital from gullible new investors.

Gary: We talk a lot about economic Armageddon. Is this it?

Dan: I wouldn’t go as far as saying that quite yet because what we have basically what I talked about earlier regarding the unaffordable debt problem. The U.S. can get away with effectively socializing the losses from all of the bad debts in the banking system for a while, but it’s going to eventually show up in disappointing economic performance, especially amongst small businesses.

And when jobs and tax receipts don’t pick back up as expected, deficits are going to surprise on the down side. We have not seen the last of the Federal Reserve’s quantitative easing.

I think we’ll see more of what I call the ‘deflation trade’ for the next few months, which means Treasury bonds will probably keep rising (yields falling) and most stocks will keep falling; the Federal Reserve is saving its ammunition until everyone’s afraid of deflation and they’ll start another big round of Treasury bond and mortgage buying, at which point depending upon how savers and global providers of capital react, it could be very, very troubling.

In a scenario where the bond market loses confidence in the integrity of the currency, we could see rising yields on every type of bond despite a weak economy; for most investors, this would qualify as economic Armageddon. Stocks and bonds would both fall in value under this scenario.

This ultimately to me adds up to why you should own gold because the confidence in the monetary system will eventually collapse if governments and central banks remain on their current paths.

Gary: They’re going to do it again.

Dan: Exactly, the key point is central banks want to maintain this low inflation outlook as long as they can. As long as the market believes that, they can keep expanding their balance sheet and supporting asset prices as much as they can get away with — , until the market says no. And we’re a long way from that, I think; we’re at least a few years from that.

Gary: Wow, but in the mean time, this summer seems to be a very good environment for falling stocks. We’re not at the end of the world quite yet, or the end of the monetary system. So there’s still a lot to be done with the falling market, which is what you do; right?

Dan: Right.

Gary: So what is the one thing that we just can do right now to make sure that we won’t be wiped out by this market that’s going to be falling a lot in this very short term, but we’re not at the point where we have to get your golden bullets quite yet, but in the near term, what should they do?

Dan: I think number one is making sure your portfolio has a heavy cash component. Number two for the stocks that you do own, be very confident in their prospects, that they’re companies that are going to benefit from the likely trends in the global economy that are sustainable, like energy and food and water and basic materials, basic necessities. The stuff that emerging economies are working hard to afford, and that most Westerners take for granted.

And number three I think if you want to hedge the market risk in those stocks, the opportunities are great to selectively short sell certain companies that will be victims of this economic scenario.

Gary: Yeah, I hear that you’re very good at that last part. Thanks, Dan. See you around the Whiskey Bar.

Gary Gibson and Dan Amoss
Whiskey & Gunpowder

June 9, 2010

Why You Need to Short Stocks Right Now was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Shorting stock is probably one of the most unusual ways to make money on Wall Street. And I think the best way to explain it is with a story.

Say a friend lets you borrow his brand-new car for an extended time. So for all intents and purposes, the car is yours.

One day, a complete stranger sees you with the car and says, “I’ll give you $52,000 to sell this car to me.”  Unsure of what to say, you take his phone number and say you’ll think about it.

You’re very curious, so when you go home, you do some research and discover that $52,000 is a very fair price for the car. But you also learn that the local car dealership is having a big sale in two weeks, so there’s a good chance the car will sell for a lot less than it sells for today.

You call up the man who wants the car and agree to the sale. You meet him, and he hands you a check for $52,000. That’s a nice chunk of change…but now your friend is out a car. Luckily, you know what you’re doing.

Two weeks later, the car sale starts, and you’re able to buy the exact same model of car — from its color to its option features — for $42,000. You’ve now replaced your friend’s car and kept a nice $10,000 for yourself at the same time.

What you’ve done is known as short selling. And short selling a stock works pretty much the same way.

Make Money Selling Something You Don’t Own

When you want to short a stock, you simply call your broker and say how many shares of a company you want to short.

The broker then “borrows” the stock shares, either from his firm’s account or from other investors. He then immediately sells those shares on the open market. The money from the sale is yours to keep.

So if you short 100 shares of stock at $50, your broker will borrow 100 shares of the stock, sell them, and then deposit the $5,000 into your account.

But don’t make the mistake of thinking this is free money. Always remember that you will need to return the borrowed shares at some point. This is called “covering the short,” or “buying to close” your position.

The goal is to cover your short for a lower price than what you borrowed it for. For instance, if the stock you shorted falls to $40, you can instruct your broker to buy shares to close your position. Your broker buys 100 shares at $40, taking $4,000 from your account to pay for the transaction. The shares he bought are then returned to whom he borrowed them from.

Meanwhile, you’re left with $1,000 of pure profits.  But notice that the lowest a stock can go is to zero. So your maximum gains will never be higher than what you earned when you initially sold the stock. In the example above, you’ll never make more than the $5,000 you got for shorting the stock.

Now, the downside to this strategy should be clear.

If the stock rises, you could be in trouble. You might have to buy back the stock at a higher price than you sold it for. For instance, if you cover your short at $60 per share, your broker will need to spend $6,000.  Since you got only $5,000 when you originally shorted the stock, you’ll need an extra $1,000 in your account to pay to close the position.  If the stock goes to $70…$80…$100…you’ll have to pay that much to cover the short. In other words, your risk is theoretically unlimited.

But it probably won’t come to that. Since you’ll need enough money in your account to cover the short, your broker may ask you to deposit more money.  (This is sort of like a margin call.)

Short traders know this. So when a stock seems to be on a run, they’ll often race to limit their losses by covering their short positions. Unfortunately, their buying can run up demand for the stock. And as you know from basic economics, increased demand leads to higher prices.

This is called a short squeeze — traders covering their shorts artificially boost a stock’s price. (In my newsletter Strategic Short Report,  we want to avoid short squeezes at all costs).

Another thing to keep in mind is that when you sell someone else’s stock, they are still eligible to receive the stock’s dividends. Since you borrowed their stock, you must pay any dividends the stock pays out.

So as you can see, shorting the stock itself is a good idea only in very certain situations (situations that will be coming up this very summer, by the way). You are forgoing the biggest gains, but your trade will tend to be less volatile. Often, this is our best route if we are confident that a stock will fall, but less confident about when.

Also, some good short-selling targets are so small that they have no exchange-listed options.

Strategic Short Report will recommend short sales in situations in which it’s the only way to profit on the downside. More often, however, we will use another option which we’ll discuss in the next issue of Whiskey & Gunpowder.

See you then.

Regards,
Dan Amoss

Getting Prepared for the Best Short Market in Years was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

First, let me make this perfectly clear:

Shorting a stock is NOT taking money out of someone else’s pocket.

You are NOT doing anything to make the stock fall in value.

And you are NOT profiting from someone else’s misfortune.

Instead, short selling is about taking a stand against unbridled greed.

Think about it — you buy puts or short a stock only if you think the price will go down. And the only reason the stock price will go down is if the stock price doesn’t reflect the company’s value. If a stock is overvalued, it’s because investors believe the company’s hype.

As a short seller, you’re looking past the hype — glaring at the company itself. And if you see there’s not as much value there as investors believe there is, you almost have an obligation to short the stock.

For one thing, shorting the stock may convince people to take a closer look…and see what others haven’t. Short sellers publicized accounting frauds at Enron, WorldCom, and Tyco long before anyone else noticed. They prepared for the bursting housing and mortgage bubbles while everyone else was busy refinancing and flipping property.

So short sellers are really the market’s early warning systems. And if investors refuse to pay attention, you can at least limit the stock’s damage as it falls.

Remember, stocks are not a zero-sum game. There isn’t a winner for every loser. If someone buys a stock at $20 and sells for $30, he’s made $10. Nobody has lost any money, though, and his profit gets recycled into the economy.

However, if he buys the stock at $20 and it goes to $10, the $10 he lost is gone forever. At least, it is unless someone has shorted the stock. A short seller has a chance to recover some of that money. So instead of disappearing, it can be re-injected into other investments.
Now then…how do we determine which stocks are in dire need of shorting? There are a handful of traits you have to look for…

5 Traits of an Overvalued Stocks

I’ve found that five things predict whether a stock is overvalued or not:

· An expensive stock price
· A contracting customer base
· A history of making value-destroying acquisitions
· Aggressive accounting
· A very generous stock option program.

Let’s take a little more in-depth look at these.

An expensive stock price

An accurate definition of an “expensive stock” is a stock that has increased far higher than the fundamentals justify.

Some bull markets, like the bull market in oil stocks, are justified. Earnings and cash flow have risen as fast, or faster, than the stocks.

Other bull markets are not justified. Consider the dot-com bubble. The huge runs in these stocks were not accompanied by growth in earnings and cash flow. Instead, momentum traders and psychological mania — hype, hope, and fear of missing out on the crowd’s profits — held them aloft. (We saw the same psychological top in housing finance in summer 2005.)

You did not want to be shorting these stocks as long as the psychological mania and momentum held strong. Expensive stocks can always get more expensive.  But make no mistake, the tide will eventually turn…and that’s when you strike.

During the dot-com bubble, that turnaround came in spring 2000. The psychology turned, and momentum traders started bailing out. Experienced short sellers knew that these stocks had an awful lot of room to fall — in the range of 90–100% declines. You could have made a fortune shorting and buying puts on a basket of the most egregiously overhyped dot-com stocks.  The classic examples: Pets.com, eToys, Ask Jeeves, TheGlobe.com, InfoSpace, Razorfish.

A contracting customer base

Obviously, companies need customers to survive.  Companies that are suffering a contraction in their customer base will experience declining sales, earnings, and even balance sheet erosion. But the Street may often fail to recognize it, choosing to value a particular stock by assuming past sales and earnings trends will continue indefinitely into the future.

An example is this would be USG Corp., a leading manufacturer of Sheetrock for use in new home construction.  It’s a low-cost producer and has a good management team. It’s owned partly by Warren Buffett’s Berkshire Hathaway. As a result, it has long been a favorite of value investors.

But building supply companies have suffered a huge contraction in their customer base. And the stock has fallen from $120 to $30. As new home construction has plummeted, earnings estimates for USG have, as well.

Company financial reports often discuss the customer base…but don’t expect them to highlight it if the news is bad.

A history of value-destroying acquisitions

Some executives are “serial acquirers.” They care more about building a personal empire than building shareholder value. They have the bad habit of constantly diluting shareholders with secondary stock issuances.

A classic example is Tyco Intl. in the late 1990s, when Dennis Kozlowski ran it. Kozlowski was a sweet talker who overpaid for a hodgepodge of industrial companies, yet he successfully marketed this conglomerate as “the next GE.”

That is, until early 2002. That’s when the seams fell apart as the Enron scandal and a recession combined to shed light on the real value of the hundreds of businesses Kozlowski had rolled up. All those acquisitions destroyed value because the negative of constant stock dilution more than offset any positive gained from the acquired companies.

Of course, expansion isn’t a bad thing. Some of the warning signs to look for are acquisitions of companies unrelated to the business…paying a stiff premium for the acquisition…or acquiring a company that’s on a downward skid.

Aggressive accounting

Companies work hard to make their earnings look as good as possible. But sometimes their number boosting schemes go too far.

Take Tyco. Its rollup strategy included an accounting tactic called “bootstrapping earnings.” Here’s how it worked: Tyco used secondary issuances of its high P/E stock to acquire low P/E companies in stodgy “old economy” industries. After the books closed of these acquisitions, Tyco would automatically show higher earnings per share. Throughout the 1990s, this conglomerate consistently produced investor-pleasing earnings growth.

How was this wave of acquisitions treated on Tyco’s balance sheet? Whenever an acquiring company pays a premium above the target company’s book value, the difference usually ends up as “goodwill,” an intangible asset on the acquirer’s balance sheet. Unlike physical assets such as plants, goodwill and other intangibles are hard to value and can, in fact, be worthless. Tyco’s intangible assets swelled from $6.4 billion in 1998 to $35.3 billion in 2001.

This was a big red flag. How could investors possibly estimate the intrinsic value of the underlying businesses?  Tyco is not a software company in which nearly all assets are contained in the minds of programmers and in lines of code. So the explosion of intangible assets was not justified.

“Bootstrapping” (and other merger-related accounting techniques) is just one of the many accounting red flags we’ll look for in the Strategic Short Report. Others include capitalizing expenses, channel stuffing, related party transactions, and using off-balance sheet accounting to hide the true financial picture.

A very generous stock option program

Companies often offer stock options as an employment incentive — promising shares of the company in lieu of money. There’s nothing wrong with that… in fact, giving staff a stake in the company is a perfect way to make sure it acts in the company’s best interests.

But sometimes a company gets a little too generous with its options. It hands them out like candy, or backdates them to make them more attractive. Either way, it dilutes shareholder value.

Take the case of Broadcom. Back in 2000, the company issued many options when the stock was above a split-adjusted $100 per share. But when the market hit bottom in 2002–2003 and Broadcom’s shares fell sharply, those options were worthless.  So to make its employees happy, Broadcom repriced those options.

Forty-nine million options with strike prices in the range of $32 were tendered in exchange for options with strike prices in the range of $22. This ultimately amounted to $49 million less for future company operations or capital expenditures.

The result was a dilution of shareholder value and, ultimately, a lower stock price.

Figuring out if a company is playing games with its options can be tricky. But once you see the warning signs, you know you’ve found a company ripe for a fall.

Of course, a company doesn’t need to have all five of these traits to be a potential loser. But it will have several of them. And once you’ve identified a target, it’s simply a matter of choosing the best way to play it. In Strategic Short Report, we’ll use one of two methods — shorting the stock or buying puts –and which will discuss in detail in coming issues of Whiskey & Gunpowder.

Regards,
Dan Amoss

June 4, 2010

Short Selling is Good was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Give me control of a nation’s money and I care not who makes her laws.”

— Mayer Amschel Rothschild

Let’s observe a moment of silence to mourn the slow demise of capitalism in the U.S.

Our government is now overtly manipulating the stock market. We have “crossed the Rubicon.” We can no longer pretend to be a free market capitalist country while also maintaining confidence in the U.S. dollar as reserve currency. After this panic subsides, the investing environment will be very different.

Make no mistake about it: The last two weeks will go down as one of the most pivotal periods in financial history. The financial landscape has changed so dramatically that few have had a chance to catch their breath. I’ve spent the entire last week reading and thinking through the free market’s ultimate response to this unprecedented, rapidly changing situation.

Last week, the SEC announced a temporary ban on new short sales in 799 specific financial stocks. Short selling is one of the most important weapons in an investor’s cache. It allows the market to react to foul play and sloppy corporate leadership. This is an even more important tool to use against poorly run small caps. That’s why this ban is so significant.

Before I go on, let’s first clear something up: This new ban doesn’t mean that existing short positions must be covered. But many are clearly closing short positions to limit risk anyway. The SEC might well have sparked a panic liquidation in other areas of the market, as hedge fund managers liquidate long positions to offset losses on short positions. As I write, the market is well off its highs just one hour into Friday’s trading day. Odds are good that the SEC will realize that its decision only sucked a huge amount of liquidity out of the stock market and reverse its decision to something more sensible, like reinstating the uptick rule.

While on the subject of the SEC’s new short selling rule, allow me to state the obvious: Short sellers did not bring down the investment banks. Once the investment bank executives made the decision to operate their balance sheets like Long-Term Capital Management on steroids, the writing was on the wall. They relied far too much on “quant” models, rather than good old-fashioned common sense.

Rather than target the individuals who had been warning about this situation for years, why doesn’t the SEC investigate the proprietary trades of the banks’ trading desks? I’d expect it would find evidence that the investment banks were short selling each other’s stocks at the same time that they were cutting each other’s lines of credit. In the autopsy of Lehman Brothers’ balance sheet, we have discovered that Lehman management wildly overvalued its toxic assets. Why wasn’t this taken as evidence that the lack of transparency at investment banks is at the root of last week’s crisis?

The SEC’s decision to ban short sales of financial stocks is throwing sand into the markets’ gears. Like most government action, it pays lip service to consequences. Convertible bond traders use short selling to hedge equity risk. After this ban, the price of convertible bonds will probably fall.

Hedge fund managers use short sales to offset the risk in holding long positions. After this ban, fund managers will have to use other means to cut risk, which include selling off huge chunks of their long positions.

Finally, at market bottoms, short sellers provide demand for stocks when they buy to close out short positions. Without this buying pressure, the market could possibly go “no bid” at crucial periods when long investors want to get out at any price.

The SEC would really benefit the market if it cleaned up the system of trade clearing. “Naked short selling” occurs when brokers take orders for short sales and don’t locate the shares to borrow. If a broker cannot locate them, then it shouldn’t tell the short seller that it is able to execute the order. Since the broker doesn’t want to lose the short seller’s business, it probably executes short sales of “hard to borrow” stocks anyway and hopes it can locate the shares in time for settlement.

“Quant funds” — the ones that use computers to trade millions of shares every minute — are lucrative brokerage clients. These funds are most likely to be the ones unknowingly requesting “naked” short sales. The orders come in so fast that it’s hard for the broker to say no, we cannot locate those shares to borrow.

In my view, the SEC can solve the problem of naked short selling with better enforcement of existing rules. Brokers should not be allowed to execute orders to short shares that they have little chance of borrowing. It’s vital that we restore liquidity to our stock market, rather than implement poorly thought-out decisions made overnight.

Best regards,
Dan Amoss, CFA
September 23, 2008

Government Regulation of Short Sellers was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“You know, you saw subprime go first, and then, on a slight lag, you saw home equity, and now in the lag, you’re seeing prime go. And it’s exactly the same loss factors. But remember, the components of where we are in the states…[are] very different. And we started doing more jumbos in ‘07, so a lot of that is — part of that is ‘07 vintage, which I think I told you at the time we were going to do and grow our balance sheet and gain share. And we were wrong. You know, we, obviously, wish we hadn’t done it.

“So when you adjust for all of those things — vintages, CLTV, stated income, where it’s done — that’s what we’re seeing. You know, it’s very early in the loss curves…

“Prime looks terrible, and we’re sorry.”

— J.P. Morgan CEO Jamie Dimon

The recent financial stock rally has all the signs of panicked short covering, rather than typical buying. Consider how the depository institutions most likely to eventually join IndyMac in federal custody — including Washington Mutual, Downey, and Huntington Bancshares — are rallying the most. So many shares had been sold short that a violent rally was inevitable.

Eventually, though, this rally should prompt two things:

1. Mutual funds selling financial stocks into strength. We’ve finally seen a shift in psychology away from buying financials on the dips. Many managers are preparing for an extended bear market in the sector.

2. Banks with capital shortfalls will announce secondary stock offerings. This will lower the cost of new capital, because higher stock prices allow the banks to issue fewer shares to raise a fixed amount of capital.

The SEC is implementing rules that will make it a bit harder to sell short stocks that are difficult to borrow.

I think “naked” short selling (shorting a stock when your broker has not yet located shares to short) must be stopped. This practice gives legitimate short selling a bad name.

Stock should be located and borrowed before it is sold short, not the other way around. If your broker cannot locate shares to short, you should move on to another idea, or use put options.

But the hysteria about “rumors” bringing down financial companies has gone too far, I think. This is the defense of CEOs who are looking to blame someone for their own incompetence — incompetence that put their firms in a vulnerable position in the first place. Short sellers did not conspire to force Wall Street firms to enter the business of securitizing dodgy debts. Firms like Bear Stearns ruined their own companies with the poor strategic decisions they made. The free flow of opinions is vital for the health of the stock market. One should be very suspicious about executives who try to suppress any negative opinions about the value of their stock. Allied Capital comes to mind.

You can read about Allied’s crusade against David Einhorn in his excellent book, Fooling Some of the People All of the Time.

Allied is still a good short idea looking out beyond a year because it’s running out of attractive assets to sell and finding it harder and harder to issue new equity.

Short sellers need to do their own fundamental research and form their own opinions. Only fools buy or sell short stocks based solely on rumors. Legitimate short sellers are very beneficial for the market. They provide liquidity at market bottoms by buying to cover their positions, and they are often the first to discover and put an end to accounting frauds and stock promotion schemes that siphon capital away from legitimate businesses.

Timing is important in the banking business. Also, as in investing, it pays to be a smart contrarian. Ideally, banks should make as many loans as possible once the economy bottoms. In an improving economy, borrowers can more easily pay down debts.

Loans made with disciplined underwriting guidelines ahead of an economic boom can be both safe and profitable.

On the other hand, aggressively expanding a loan book at the peak of a credit cycle and an economic cycle can lead to disaster.

Once credit cycles turn, loan portfolios, or loan books, become sources of risk, rather than profit. Look at the experience of Countrywide, which just got acquired by Bank of America for a fraction of is peak value. It blew itself up by aggressively expanding its mortgage loan book at the peak of the credit cycle — which happened to coincide with the biggest housing bubble in history.

Regards,
Dan Amoss, CFA
August 21, 2008

P.S.: You want to form your own opinion of a company and ignore herd behavior and rumors. But sometimes that can be difficult. Aren’t we all getting our information from the same places? Well it doesn’t have to be that way. Some people are getting their information straight from the source. They’re called “100-F” documents and they tell you exactly what a stock is going to do.

Short Selling was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.