Some Truths About Short Selling
The Strongest Stock in the Market?
For the first four weeks or so of this market correction, which began on May 1, the environment wasn't too bad. The major indexes were down 2% or 3% from their highs, and while many leading stocks were faring worse, it wasn't a horror show ... more of a consolidation than a huge retreat.
However, since June 1, there's no doubt that the market's character has changed, with sellers starting to unload--all indexes have hit new correction lows, and many stocks (even those that had been holding up well) have been hit very hard. And, as usually happens a few weeks into a downturn, the news has turned bearish--last week's unemployment report was just the latest in a long line of disappointing economic reports.
That's led to some scary headlines and a ton of predictions from pundits. Some are predicting a huge bear market, while others think a massive bullish turn is about to occur. (I actually read an article talking about Dow 20,000. Seriously.) But it seems as if everyone has an opinion on where the market is headed in the months ahead.
What do I have to say about all this? My main thought is that predictions have nothing to do with making money in the market. The successful investors don't concern themselves with labels (secular bull, cyclical bear, correction, pullback, rally, etc.) or what will happen six months down the road. Instead, they focus on the ever-present moment of now--if the market is unhealthy, as it is today, you remain defensive and focus on preserving capital. If it's bullish, you buy stocks according to your system. That's it.
The desire to predict what will happen months down the road stems from too many investors not a having a system they trust. In our case, our trend following system isn't perfect--there are usually a couple of whipsaws (signals that are quickly reversed) during the year--but I know that we're guaranteed to not only catch every major bull run, but also avoid every major, prolonged decline.
In practice, that means that my Cabot Market Letter subscribers have been defensive for more than three weeks (50% cash, which has risen toward 60% this week). And that means there's no need to panic at this point--we are still monitoring our current holdings, of course, but with so much cash the pressure is mostly off.
It also means that I'm confident our system will identify the next uptrend. I don't have to throw out guesses about when things will turn around. We just take it day-by-day, week-by-week, and wait for the environment to improve. That's what you should do, too.
For example, when we first turned defensive in November 2007, we had no idea that a year later, the economy would be in the worst crisis since the Great Depression and that the Dow would be below 8,000. And we didn't have to know that! All we did was follow the market's trend (down) and remain defensive until the bulls re-took control. (There were a couple of brief buy signals but we averaged a cash position of more than 50% during that time.)
Obviously, that's an extreme example, but the point is that predictions don't help you ride bull trends or avoid bear trends--time-tested systems do.
For what it's worth, I still don't think the evidence supports a major bear phase from here; the typical bear market warning signs (like deteriorating breadth, which reflects a huge number of new lows as the indexes hit new highs) never appeared around the Dow's top. But the market doesn't care what I or anyone else thinks, so I don't take any action based on thoughts like this. Instead, I'll just take it one day at a time, patiently waiting for the all-clear signal to tell us when to begin a new buying spree.
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Switching gears entirely, I want to touch upon the topic of short selling, whether via individual stocks, or by inverse exchanged traded funds that track an index or sector. There's nothing wrong with playing the short side, but remember a few key points if you do.
First, write this down on a sticky note and tape it to your computer monitor: "Stocks take the stairs on the way up and the elevator on the way down"--i.e., stocks fall a lot faster than they rise. That means that your timing has to be very precise on the short side; if you're just a day or two early or late, the trade could go awry. So try to short only after rallies into resistance in the market and most sectors.
Second, instead of letting winners run, it's usually best to take profits often on the short side. The declines tend to happen within a few days or couple of weeks, followed by lots of choppy action and the occasional vicious short-covering rally. Smooth, persistent downtrends are rare, at least among major indexes and sectors.
Last but not least, remember that the major indexes today are still in long-term uptrends; the S&P 500 and Nasdaq Composite are above their 200-day moving averages, and one simple long-term indicator (the market's one-year return) still points to an overall bull market. Thus, while there's no doubt the intermediate-term trend is pointed down, diving in on the short side during a longer-term uptrend can be dangerous.
Personally, I've never made much money on the short side; I prefer to just hold cash during a downturn because the truly big money is made by owning leading stocks during a big market upmove. I spend my time looking for resilient stocks with great growth stories that can take off when the bulls return.
That said, there's nothing wrong with playing the short side, but just be aware of the risks if you go there.
For my stock pick today, I'm turning toward the biotech sector, which has held up well during the market's maelstrom. Granted, most of the time in the biotech world, all you can find is a lot of pipe dreams with stocks that are knee deep in clinical trials and only hope to launch a new drug candidate. I generally stay away from such firms, because they can fall apart in a hurry if the trials go awry or if a competitor jumps into the fray.
So my stock pick today is ... a small company with no sales and one major drug in clinical trials. Not joking! I don't advise buying it here, but I am writing about it because it is, by far, the strongest stock I know of in the entire market.
It's Pharmasset (VRUS), and the big idea here is a drug candidate with the sexy name PSI-7977. It takes aim at Hepatitis C, a hot area in biotech these days, and the trial results thus far have been more than encouraging. I don't pretend to know all the ins and outs of the disease, but when combined with other treatments, a huge 98% of patients saw improvement with Pharmasset's drug. And when two of its own drugs were used together, 15 of 16 patients had undetectable levels of Hep C within two weeks!
Plenty of analysts are on board with huge price targets because they believe this could prove to be the drug in the industry ... if and when it gets approved in a few years. Again, this is highly, highly speculative, but what caught my eye is that, first, it was strong enough to appear in Cabot Top Ten Trader a few weeks back (where I screen for the strongest stocks in the market using a combination of short- and long-term relative strength metrics).
Second, I was intrigued that, after breaking out of a base in early March, VRUS doubled in just seven weeks. And after that ... it went straight sideways, even with the market weakness. Then, just yesterday, the stock soared on monster volume after it expanded its trial size ... a clear sign that the trials are going very well with little in the way of side effects.
Should you buy some here? I wouldn't, at least not in any meaningful amount. This is the type of stock that could fall 20% in a day or two if things turn sour. But I definitely think it's worth adding to your watch list, and learning more about the story's potential as the market works through its correction.
All the best,
Editor of Cabot Market Letter
Editor's Note: Mike Cintolo is VP of Investments for Cabot, as well as editor of Cabot Market Letter, a Model Portfolio-based newsletter of the best leading growth stocks in the market. It's been over four years since Mike took over the Market Letter, and during that time he's beaten the market by 13% annually (up a total of 65% since then, compared to a loss of 6% for the S&P 500) thanks to top-notch stock picking and market timing. If you want to own the top leaders in every market cycle, be sure to give Cabot Market Letter a try by clicking HERE.