Reviewing the art of Short Selling

Reviewing the art of Short Selling

I know from experience and from reviewing many of the questions I get from TradingMarkets.com subscribers that many of you following my commentary and techniques have not been using our short-sale criteria diligently or properly. Investors should realize that so far this year our short-hedges have contributed half of our total profit -- and if we get new lows in the Nasdaq, Dow and S&P, I would expect shorts to make up the vast majority of our profits this year. For this reason, I want to review the criteria listed in my book, and in my 10-week trading course, with regards to short sales. I also want to cover how we adjust this strategy if a real bear market appears so that TradingMarkets.com subscribers are ready and able to pounce on the fast profits that shorts in a bear market can create.

Each week I comment on all stocks that meet our upfuel criteria and have broken out of valid 4+ week flags or cup-and-handles, as well as all stock that meet our downfuel criteria and have broken down out of valid 4+ week down-flags and down cup-and-handles. Let's review those criteria, which we use in all market environments. If you also need to review how we use breakouts to determine exact entry and exit, please review my 10-week trading course, free and available to all TradingMarkets.com subscribers. You may also want to review my book or Science of Trading courses, available via M. Gordon Publishing through TradingMarkets.com, to become more expert at implementing this strategy.

Criteria for finding short-sales with minimum downfuel:

1. Earnings: Either

(a) a decline in annual earnings and an estimate of either an annual loss or another decline in annual earnings, plus two down quarterly earnings or two negative quarterly earnings; or

(b) two quarterly earnings down 40% or more, or two negative quarterly earnings with acceleration in the decline; finally if either criteria "a" or "b" are met, the stock remains a short-sale candidate from an earnings criteria standpoint as long as quarterly earnings continue to be lower than year earlier quarters or continue negative. (For maximum fuel, either the above are met or a stock has two quarters in a row of declining earnings and declining sales, and a price/sales ratio (P/S) >10 and PE>S&P's PE.)

2. Runaway technical market characteristics down are displayed on the daily or weekly chart.

3. EPS and RS rank both <50.

4. Yield 5% or <. (For maximum fuel must = 0.)

5. Debt -- must have some, the more the better, over 100% ideal. (Max. Fuel >99.)

6. Funds -- must have some institutional ownership, >30% is optimum. (Max. Fuel >20.)

7. The worst or second-to-worst rating by Value Line, Zachs, or Lowry's rating services.

8. (Max. fuel only -- must be a clear bear market in stocks if stock is related to market -- according to Chartist, BCA, bond/bill/index rules, or PSL systems.)

9. (Max. fuel only -- forming or formed weekly or monthly pattern of Double Top, failed rally, or Head-and-Shoulders Top and P/S >10.)

This allows us considerably more flexibility to adjust our portfolio to the U.S. market. We can create a fully hedged fund -- or adjust our short positions to offset as much of our long U.S. exposure as the market environment dictates. As Julian Robertson said, "Our goal is to own the best companies and be short the worst companies." Over the last decade, our short criteria have helped us to: 1) determine when the U.S. market is starting to weaken as these stocks usually begin to accelerate down just before a broad market; 2) effectively hedge a broad decline as these stocks tend to under-perform our longs and the market during corrections in particular; 3) profit from a bear market, rather than be chewed up by it; 4) clean-up from a two-way market environment where some stocks are still moving up or down and others are moving consistently in the opposite direction, as usually develops during transition periods when the major trend is changing; and 5) get advance notice of when serious changes in the market are occurring (as we were able to take 1/3 profits on everything in early March of this year) because we're watching the action of both the weakest and strongest stocks in terms of their respective trends. Thus, while we do not recommend a fully hedged portfolio at all times, we do recommend covering part or all of your long exposure via shorts during times when the interest-rate environment is neutral - negative, when the U.S. technicals are poor, or when overvaluation is extreme enough that systemic market risk is unusually high, but an all-out bearish signal has not yet been given. Only when the U.S. and most global markets have generated universal bearish signals, would we become net short as part of our allocation strategy.

Like our longs, investors should use flag-down breakdowns of 4 weeks or more and valid cup-and-handle down breakdowns of 4 weeks or more as signals of when and where to short stocks meeting the above criteria. As you get more proficient at locating stocks that meet this criteria and then looking only for trades in stocks meeting these criteria and also breakdown out of valid patterns, you can refer to my weekly commentary to confirm that we're finding exactly the same stocks and that you're following the technique properly. In fact, that's what my weekly commentary is for -- it's designed to help those trying to utilize this specific technique to trade the markets. Many investors at first had questions as to why a stock they thought met the criteria wasn't included -- but as I've answered these questions over time most investors following this technique for many months studiously now understand that I am commenting on absolutely every stock that meets these rigid criteria and that an investor working hard on following this technique can have very nearly identical results as the ones reported in my weekly column. Over the first year-and-a-quarter or so, most criticism and commentary have come from traders who have not thoroughly studied my courses and this technique. So far, at least, I have not yet heard from or met a trader who has tried diligently to follow this methodology religiously who has not been very happy with his/her trading results.

We basically exit short stocks on: 1) Positive turnaround in earnings; 2) whenever their PE gets below their expected growth rate; 3) whenever they violate their 200 MA by 10% or more; 4) take half profits on 40% decline from entry and then begin using any high with six lower highs surrounding it as trailing stop; 5) on every new low use ops above correction high as trailing stop; 6) exit if Relative Strength rank or EPS rank ever move above 50 from below it; 7) on any weekly chart double bottom or head-and-shoulders bottom; 8) whenever the stock reacts positively to what should clearly be negative news, or on positive reaction to restructuring or new management.

Although the odds are now tilting toward the current (5/00) environment being a bear market, I am not solidly convinced that we are there yet. It would take new closing lows in the Nasdaq, S&P and Dow below their respective February-March lows before I will be fully convinced that we are in another leg down of an ongoing bear market. I would also like to see at least a week of consistent 20+ number of stocks on our Bottom RS/EPS New Lows list, and a much higher concentration of valid breakdowns in stocks on these new lows list. Similarly, I would like to see a large concentration of specific industries dominate the new lows lists. If we get all these factors coming together, than for the first time since 1994, investors will need to look for and allocate more capital to short selling.

The above "downfuel" criteria for finding short-hedges is valid in a bear market, as in a bull or sideways one. However, to maximize profit in a bear market (assuming all of the bear market factors mentioned above come to pass), traders should also look for major topping patterns in former leaders running out of gas, for about half of their short-sale exposure. As we get more of these patterns and more of our typical short-hedge exposure, investors should add about 7% of capital per new short trade and stop at about 24 positions. You basically let the market determine the number of shorts and longs by how many valid breakouts or breakdowns you get. Hold back on adding more than two new positions short or two new positions long in any one week. Theoretically, you could get to be 200% long or 200% short in an extremely strong or weak market. To find former leaders running out of bas, get our your Daily Graphs booklets or look at a huge number of stocks on a weekly-chart basis. Screen for stocks that are forming six month+ topping patterns such as Double Tops, Triple Tops, and Head-and-Shoulders Tops over a very long period of time. From this list of potential topping pattern stocks, look for over-valued equities with a P/S > 3 (ideally >10) and with a P/E much greater than the last year's earnings growth and much greater than the next year's projected earnings growth. Next, from this smaller list of potential shorts, look for stocks where earnings growth rates are slowing down. The big money is made shorting major chart breakdowns in stocks where expectations have been out of line with reality, that are starting to disappoint investors that held those out-of-line expectations. Only look for these stocks when you are very sure that we're in a bear market. We'll try to point out some such issues as examples, should we become convinced that a real bear market is in progress, in our weekly commentary in the weeks and months ahead.

Most traders have only looked at our long-side upfuel criteria and buy rules. Now is the time to review our short-hedge strategies and our aggressive short rules for bear markets. By using these strategies along with our long-side rules, investors can achieve smoother long-term returns, higher long-term gains, and more consistent profits in their stock trading accounts.