Seven Reasons to Sell Stocks Short

With all that’s going on, would you believe the market, as measured by the S&P 500 index, is only 4% off its high? Some folks interpret this fact as investors “shrugging off” bad developments, looking ahead to some unseen, glorious future that none of us individually can imagine.

But the “wisdom of crowds” is overrated. I see an epidemic of denial — denial at a level last seen near the 2007 market peak, when central bank policy was thought to be propping up stock prices. That denial didn’t end well.

Psychology and sentiment are important in markets, but not as important as overwhelming negative evidence, including the following seven reasons to remain bearish (the reasons to be bullish are well-known among institutional investors who have nervous clients’ money fully invested):

1. The market shrugged off the abysmal ISM report last week, but it shouldn’t have. This measure of US manufacturing activity dropped to 49.7 in June from 53.5 in May. This is the first time since July 2009 that we’ve seen a sub-50 ISM figure. Even more importantly, the index of new orders fell from 60.1 to 47.8 — its steepest month-to-month decline in a decade.

2. Central banks are panicking and easing policy, yet they’re still behind the curve in propping up stressed credit markets. Yesterday, the ECB, Bank of England and People’s Bank of China all eased policy. The Chinese in particular are starting to realize that easing credit policies would only worsen its overcapacity problems and are starting to think about the hard (and “growth”-depressing) work of restructuring a hugely imbalanced Chinese economy. At this point, the Federal Reserve is the only game in town. The Fed disappointed speculators in June by merely extending Operation Twist, and is unlikely to fire another volley of digital cash until the stock market and economy are in far more panicked states.

3. I didn’t address the so-called “plan” issued by the European Union a week ago because there was nothing to address: no details, no firm cash commitments and only vague promises to have another plan. Yet the stock market rallied anyway. The proof is in the pudding (and the “smart money” moves are reflected in the bond markets): Spanish government bond yields are soaring above 7% as I write. A real plan for Spanish banks will have to involve haircuts for shareholders and bondholders. There simply is not enough money — nor is there enough political capital — to bail out so many parties. We will see fewer month-long European vacations among the bailout crew this summer, and more emergency conference calls and meetings.

4. Leading economic indicators, including the ECRI Weekly Leading Index, rolled over in the spring and remain negative.

5. Nonresidential fixed-asset investment has peaked, as many companies go on an investment strike. Policy uncertainty is too great. The job market tends to follow the investment cycle; it has softened in recent months, including the data from this morning’s payroll report.

6. Forward earnings estimates for the major stock indexes are rolling over, starting from record levels and record-high profit margins. This is something we’ve discussed frequently in the past, but we’re seeing more and more earnings warnings related to squeezed profit margins. You can find more detail in the publicly accessible PDF chart book from Yardeni Research at this link.

7. Valuations are not low enough to compensate stock investors for all of these risks. You can see in the PDF document linked above that trailing earnings will likely turn out to be a good deal higher than forward earnings. This makes trailing PEs deceptively low and creates a strong head wind against future growth in dividends.

In summary, hold your short positions.


Dan Amoss
for The Daily Reckoning

The Daily Reckoning