Saturday, February 19, 2011
Editor's note: Today, we're doing something a little different... We're talking with one of the best traders we know, Jeff Clark.
I hardly have to detail Jeff's record of finding huge winners. One of his favorite strategies these days is to trade short on "busted momentum" stocks. Readers netted 77% in two months on the first busted momentum trade. The second was a two-week, 65% return. Jeff's last two busted momentum trades are still proving themselves out, but could make between 140% and 500%.
So I asked him to explain how these busted momentum trades work... and the best spots for trading today.
Sean Goldsmith: Jeff, over the years, you've traded "busted momentum" with a lot of success. Can you explain to readers how this works?
Jeff Clark: Sure. It's really not that complicated a strategy. Basically, a lot of momentum traders look at the 50-day moving average as an important pivot point on a stock. If a stock's trading above the 50-day moving average, it's in a bullish pattern, and momentum traders will be buying it. If it's trading below the 50-day moving average, the momentum traders look to sell it.
And so what I've done a lot of times with some success is, when a stock crosses back above or below its 50-day moving average, we use it as a key reversal point.
When you have a market that's been as overbought and as overextended as this one, short sellers – pardon the pun – take it in the shorts here. It's difficult to keep trying to time the top of the market.
So I look for stocks to roll over and actually break down below their 50-day moving average. And a lot of times, this happens in overvalued situations and overextended situations. So when it breaks the 50-day moving average, you have a shift in momentum. That happens quickly, and it's usually a fairly significant move to the downside.
As I caution repeatedly, as anxious as folks are to short stocks, you don't want to chase a stock lower. You want to sell a stock short when an oversold bounce occurs. So you watch for a stock to fall down below its 50-day moving average. Usually that's accompanied by high volume and a large move lower.
Then you wait for an oversold bounce to come in and come back up and just basically "kiss" that moving average from below.
(Goldsmith comment: Here's what it looked like on one of Jeff's recent trades...)
And that sets up the ideal short sell opportunity, because at that point, you have a fairly low-risk entry point. The stock has had its oversold bounce, it's no longer beaten down into the ground, and if that 50-day moving average holds its resistance, the stock should turn around and start falling lower right away.
If the stock can somehow manage to get back above the 50-day moving average, the whole pattern is moved, and we're off to the races once again... and you close out the short sell usually at a very small loss.
Now you have to have some flexibility with this, because in this day of high-frequency trading – where you've got computer algorithms and everything else running the market – folks who are programming know that we traders pay attention to this sort of thing... We've got to give it a little bit of room on the upside and the downside for the pattern to hold out.
So it's not a hard stop at the 50-day moving average, but it's something you keep in the back of your mind. And like I said, it gives you a low-risk opportunity to jump in.
Sean Goldsmith: When you buy a put option for a bearish bet, how many months out do you typically go, and what strike price do you shoot for?
Jeff Clark: Well, it's tough to answer that because it depends on several factors... the price of the option obviously being one of them. Right now, we have a situation where it really doesn't cost that much to buy put options going out several months. So in this particular type of environment, I'm good with buying something three, four, even five months down the road.
Most of the time however, that's not a viable alternative, because the expense of the option increases just too much. Often I'll go with about a two-month timeframe.
And I like to trade options that are as close to "at the money" as possible. I'm not doing this yet, but I'll use Chipotle Mexican Grill as an example. The stock's trading around $260 a share. I would try to look for something around a $260 strike price. Again, price is a factor there.
Now the other thing that's important and I think has to be pointed out, what I like about using options instead of shorting the stock itself is, it's an automatic limitation of risk. Netflix is trading around $220 a share – to sell short 100 shares of that stock, that's a $22,000 trade. Whereas, I can go over to the option market and I can look at buying a put on it, and the put option itself would probably cost me around $1,500.
So rather than having a lot of capital at risk, we would have a minimal amount of capital at risk. If the stock continues its upward trajectory and just blows everybody out of the water, at least I know my risk is limited to $1,500.
And here's the key point with that. When you're using options, don't over-leverage the trade. Rather than putting $22,000 into the stock, you put $1,500 into the option. If you would normally short sell 100 shares of stock, buy one put option.
If you normally short sell 500 shares of stock, then you'd buy five put options. You don't go nuts and buy 20 or 30 or 40 of them and overleverage the trade, because that eliminates the whole benefit of reducing your risk by using put options.
Sean Goldsmith: How has shorting changed since you started doing it 25 years ago?
Jeff Clark: Well, the option market is much more efficient now. So rather than short selling stocks, we go to the option market. I rarely short sell a stock itself. I'll always go to the put options and use it that way.
Put options now trade in penny increments, so the spread between a "bid" and the "ask" is a whole lot tighter. Twenty-five years ago it was not uncommon to have a $0.30, $0.40, or $0.50 spread between the bid and the ask. And in some cases, that's a 10% difference on the option. That's a tough way to trade.
Now you've got penny increments, so it's much more efficient, much more price effective, and easier to do. Also, in the stock market itself, 25 years ago, you had a short sell uptick rule where you could only sell stocks short on an uptick. That prevented a lot of the strategies where you're looking to short a stock as the momentum shifts to the downside. You couldn't do that, because you had to wait for the stock to tick up.
So that doesn't exist anymore. If you wanted to do a pure play short on the stock itself, it's much easier to do that now. It's also a much more popular strategy. I think 2007 woke up a lot of people to the ability to profit as the stock market falls, so you have a lot more folks that are interested in doing that.
And there's a little more competition out there to get shares to short, which again, is another reason to go into the option market, because you don't have to worry about trying to find a brokerage firm that can lend the shares to you.
Sean Goldsmith: Are there any sectors out there right now that folks should have their eye on shorting if the broad market enters a period of weakness?
Jeff Clark: The sectors that are most vulnerable to a pullback here are obviously the sectors that have been some of the best performers. Restaurant stocks come to mind. You can look at something like Chipotle Mexican Grill, which is straightening into a 52-week high, or Panera Bread... same story with that.
Not only are restaurant stocks trading at relatively high valuations, and not only are the charts extended, but they're also subject to rising input costs – that's inflation. And food costs have gone up considerably over the past few months, and the restaurants aren't yet passing those rising prices on to consumers.
At some point, you're going to see a margin compression. You're going to see where the cost of the ingredients that go into the food or that go into the meals at the restaurants are more expensive than what's being charged itself. Margin compression is what we're looking for here.
And we're also looking for stocks that have a large amount of debt that's rolled over recently. Obviously, with interest rates on the rise, any company that's looking to issue new debt to replace old debt is going to suffer the disadvantage of that.
Sean Goldsmith: Can you go into more detail for new folks about how rising interest rates are bad for stocks?
Jeff Clark: Well, there are a couple simple explanations...
First off, from a fundamental perspective, any company that's borrowing money to do business increases the cost of new funds. Secondly, it also increases margin rates on investors. Folks who are buying stock are paying a little extra, so they demand higher potential returns.
But really, the main crux to this is bonds that offer higher interest rates are much more competitive relative investments to stocks.
So you have a situation – and I just pointed this out last week – like back in 1987. At that time, stocks had this unbelievably remarkable rally. I think they were up 25%-30% by the middle of the year, and interest rates were also spiking higher at the time. Interest rates were, I think, a little over 7.4% in early 1987... And by August, they were up around 9.2%. So you had this dramatic rise in interest rates as the stock market was going higher as well.
When we started 1987, stocks were relatively cheap and bonds were relatively expensive. And then those two movements, the higher rates and the higher stock prices, created a situation where bonds were relatively inexpensive and stocks were relatively cheap.
An investor looking to put new money to work could put money into a stock market that was overextended to the upside, where there was a significant risk of a correction, and where the upside potential was somewhat limited to that point. Or they could put it into the bond market, where the 30-year Treasury was offering 9.2%. So the Treasury bond became a competitor to stock prices.
You're looking at sort of the same situation now. We've had interest rates on a sharp rocket ride since last September. The 30-year Treasury yield bottomed at 3.5%, and now it's up near 4.8%. That's a dramatic increase in a very short period of time. At the same time, you have stocks that have gone from 1,050 on the S&P last September to 1,325 now. That's also a dramatic rise in a very short period of time.
So we reversed the situation again. We went from a period where bonds were expensive and stocks were cheap, and now we have the opposite. Bonds are cheap and stocks are expensive. Somebody looking to put new money to work here can say, "Well, I can lock in 4.75% on essentially a risk-free basis on the Treasury bond market, or I can throw money into the stock market." The analysts are looking at about 1,375 to 1,400 on the S&P by the end of the year. That's another 4% or 5% from here.
You've got risk in the stock market, and you have a perceived-risk-free rate that's equivalent in the bond market. The threat of higher interest rates is that you have a stronger competitor to stock prices.
Sean Goldsmith: One of the sectors that looks vulnerable here is the airline stocks, which have soared in the past few years. Do you think this classic "boom and bust" sector is ripe for a short sell soon?
Jeff Clark: Well, yes and no. Airline stocks aren't the same monsters they were years ago. Many of them have restructured their labor union agreements. They're a lot trimmer. There are a lot of things that are going well for the airlines at this point.
Now, obviously, historically, airline stocks have been losing investments. I think the aggregate net income for the industry is a loss since its beginning many, many years ago. So I'm not a big bull on airline stocks. And quite frankly, I'll use any excuse I possibly can to get out of flying, because flying has become such a hassle.
I'm not a big fan of the companies themselves, but at the same time, if you want to get from California to Paris, your only choice is to fly. So you're going to pay the prices, and you're going to put up with all the garbage you have to put up with just to be able to get around.
I don't have them on my list of stocks that I'm anxious to short anytime soon, but I think the folks who provide services to the airlines – folks like Expedia, Travelocity, or Priceline – those are interesting short sell candidates, especially as the momentum on those stocks starts to fall.
Look at what happened to Expedia recently. The stock was down 15% on an earnings mess. That sort of thing is more interesting to me than shorting the airlines themselves. I'd rather short folks who are providers to the airlines.
Sean Goldsmith: What do you think of Jim Chanos' much-publicized short bet on China... and on raw material producers like iron ore giant Vale?
Jeff Clark: Well, Jim and a lot of very smart hedge-fund managers are short China. And then, folks like Jim Rogers and a lot of other very smart hedge fund managers are bullish on China. So it's really tough to argue either way.
I think the main problem in China is it's tough to get accurate information, and you have to question the details that you have.
I've traded some Chinese stocks before, and I got mixed success with that. A lot of times, the stocks where I've made errors, I've made because the information I got or the data I got on the companies was inaccurate. They're subject to different reporting requirements than American companies, and it's difficult to trust the information that you get.
Unless you have somebody over there who's watching the individual companies and can tell you first-hand that what is written in the reports is accurate, it's tough to make that call.
If Jim Chanos says short Vale, I'm not going to argue with him about that. He's a smart man, and he's certainly earned his medals in the market. He probably has that sort of information. As far as China, technically it's in a downtrend, and the momentum, obviously, is working to the downside, so he's got the wind at his back at this point.
Sean Goldsmith: Great. Thanks, Jeff. Are there any last words you'd like to share?
Jeff Clark: Well, right now, you have an interesting situation in the market, which is overextended. You have bullish sentiment that is truly off the charts, and interest rates that are on the rise, and all of this stuff looks remarkably similar to what happened in 1987.
And I remember as a broker in 1987 just banging my head on the wall multiple times between April and August, because I just could not get a handle on why folks were buying stocks in what I deemed was a very risky environment. And of course, that risk all came to pass in October, when the market crashed several hundred points and everybody got shaken out of their long positions.
And I hate to say we're headed to something similar to that, but I don't see how it can't occur that way, especially when you have so many folks right now conditioned to be buyers on any pullbacks at all, you have so many mutual funds sitting on very little cash, because they're forced or they're pressured to be fully invested at this point, and you have such wild investor sentiment on the upside.
We're making the same recipe we had back in 1987, and I know there's been several times since then where we can peg similar conditions. But the pivot is the rising interest rates. I think the rising interest rates are going to take their toll. Once the 30-year Treasury gets up around 4.9%... that's really the tipping point. And we're dangerously close to that right now.
So I'm anxious to get short. I have a couple short positions, and I'm underwater on that. But I haven't been aggressive on the short side, simply because it's been a fool's game to try to short the momentum behind this market.
There's a point that's coming, and I think it's coming soon, where we're going to pay the piper. And it will be a time to be all-in on the short side. I think we're getting close to that. We're not there yet, but when we are, I'm anxious to put some of these ideas we've talked about today to work.
Sean Goldsmith: Great. Thanks so much for joining us today, Jeff.
Jeff Clark: My pleasure.
Growth Stock Wire and DailyWealth readers have read Porter's thoughts on rising interest rates and how those play into his End of America thesis. As you just read, Jeff is also watching this trend – and trading on it. His readers have doubled their money – or more – with short bets on Treasurys and long bets on "real assets" that profit as the dollar declines.
You can access all Jeff's research and his latest trade in the S&A Short Report. Click here for details.