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Bright Spots And Short-Selling

01/02/13 11:01:45 AM
by Billy Williams

The market is anemic at best, so shorting stocks makes sense. But when there is blood in the streets, there is an even greater opportunity if you know what to look for.

Security:   SPX, RFR, HLF
Position:   Sell

No news is good news lately as traders try to size up the economic outlook and develop a strategy for it, but reports are a mixed bag with a bias on the negative side of things. Housing starts have slowed, but building permits have spiked higher, but the one thing on everyone's mind is the fiscal cliff in the US, narrowly averted. The negative impact could have serious repercussions for a weak market that could spill over into the overall economy, which is already anemic at best.

The SPX has still managed to creep higher as it crawls higher inside of a rising wedge pattern. Price has continued to trade within a contracted price range where the wedge has formed and could mean that a reversal is likely.

Since chart patterns are a reflection of the mass psychology of the traders that make up the activity in a given market, the rising wedge indicates that traders are undecided on a dominant trend, though it is trending higher in the meantime, and appear to be ready to leave the market quickly if a catalyst comes along and sets off a chain reaction of mass selling in a short period of time. See Figure 1.

FIGURE 1: SPX. The SPX has formed a rising wedge pattern that could spell the end for the bulls and pass control of the market to the bears if some catalyst sets off a decline.
Graphic provided by:
What do you do if the market reverses and moves within conviction to the downside as the bears take control of the trend?

The obvious answer is to identify the segments of the market that are weak and/or likely to be greatly affected by such an event and short those stocks or use put options. Already, hedge fund managers are doing just that. See Figure 2.

FIGURE 2: HLF. Hedge fund managers are already taking short positions such as the one in HLF. As a result, the stock has plunged sharply and likely to continue.
Graphic provided by:
The not-so-obvious answer is to start looking for value stocks when the rest of the market is in a panic. The ability to keep a cool head when everyone else is losing theirs has been responsible for more wealth creation than possibly any other single skill or ability for investors and traders ranging from Baron Rothschild to Warren Buffett.

In the wake of the horrible shooting tragedy in Connecticut, gunmakers stocks are reeling from the fallout. One obvious short candidate for bears but also a strong value candidate for stockpickers is Sturm, Ruger & Co. (RGR), which engages in the design, manufacture, and sale of firearms in the US. With revenue of $443 million, a profit margin of 13.84%, an incredible return on equity of 39.47%, and zero long-term debt, RGR has all the fundamental factors necessary to be a strong-performing stock in the long term. See Figure 3.

FIGURE 3: RGR. Gunmakers like RGR are an obvious target by the bears given the tragic shooting in Connecticut during a bad time in the market. However, declines in price are an opportunity not just for shorting the stock but buying value as fundamentally strong gunmakers are suited to weather the tough times with strong durable competitive advantages for the long term.
Graphic provided by:
Adding to that a strong durable competitive advantage in its brand and market share, RGR also appears to have Warren Buffett's secret ingredient for an economic "moat," giving it the potential for outsized gains that could materialize over time.

With legislators and gun activists energized by the tragedy, you could see RGR's price driven down by negative news and/or lawsuits. Combine that with a weak market that could turn over to the downside and you've got a buying opportunity.

Revenue per share is at $23.18 and shareholder equity at around $7 a share, making $30 a share within striking range. However, these are volatile times, so having a strong margin of safety of around 66% of value would be a minimum, making $18 a share an optimal buying point for a position.

Keep in mind that RGR isn't the only bright spot for value buyers during a market downturn, since such downturns create massive buying opportunities across the market. However, during such times, the key factor for taking any position is simply being more selective and buying quality versus quantity.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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