News Analysis date published New: 
Monday, August 13, 2012 - 15:00
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Monday, August 13, 2012 - 18:05
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Monday, August 13, 2012 - 15:00

Now is the Perfect Time to Short These Stocks

Monday, August 13, 2012 3:00 PM

The art of short-selling is inextricably tied to the direction of the market. If the market has sold off for a number of sessions, then it's risky to short stocks. This is because a reversal from oversold conditions can push many stocks higher and propel heavily-shorted stocks at an even faster pace as short sellers cover their positions.

The converse is also true. A market that has been moving upward for an extended period actually sets up a favorable entry point for investors looking to short a stock. Other short sellers may have already been shaken out in the market rebound, and if the market reverses itself from a recent uptrend, then short sellers become emboldened anew to re-visit their favorite targets, creating fresh selling pressure in heavily-shorted stocks.

To my mind, the set up for short-sellers is looking better. The recent upward trend, which has seen the S&P 500 tack on more than 100 points since early June, doesn't have much more room to run, in my view. In early August, I warned that a series of challenges are ahead, and the higher the market goes, the greater the chance that these headwinds will have to wreak havoc.

This is a time for booking profits -- and looking at stocks to short.

Though I typically give an occasional look at some of the most heavily-shorted stocks by the size of their short position, I am looking at short candidates by another gauge today. Specifically, I am looking at short ideas among the stocks that have very large short positions in relation to their trading float. A fresh set of short interest data has just been released, and here's what popped up on my radar.

The For-Profit Schools
It's no coincidence that Strayer Education (Nasdaq: STRA), ITT Educational Services (NYSE: ESI) and Bridgepoint Education (NYSE: BPI) have 31%, 49% and 48% of their tradable shares in the hands of short-sellers. (The trading float is smaller than shares outstanding because it doesn't include shares that are closely held by management or major shareholders.)

These operators of for-profit schools have already seen their shares pummeled in the past few years, but short sellers are betting there is even more pain to come. The most obvious challenge comes from Washington, where Congress remains dubious of the value proposition these schools offer. A key factor behind the enrollment at these schools is the ability for students to get government guarantees on their student loans. If Congress decides to simply stop any federal loan backstops for these for-profit schools, then these schools could see their enrollment drop even further.

The tough economy is also a factor for short sellers. Graduates from these schools are having a hard time landing jobs in this still-tough job market and that news may be spreading to friends and colleagues that had been contemplating enrolling themselves. These schools are all expected to see enrollment (i.e. sales) fall at a high single-digit or low double-digit pace this year, though analysts expect to see smaller drops in revenue (or even a modest gain for Bridgepoint) in 2013. But short sellers are betting that this industry is nowhere close to stabilizing.

Another Housing Pullback?
The housing market is showing tangible signs of life. Prices for used homes have begun to rise in some markets and foot traffic into realtor's offices is also on the rise. Many Wall Street analysts think they've spotted a trend and that builders of new homes will see improvements in 2013 and perhaps a full-fledged robust rebound by 2014.

Of course, those views were formulated this past spring when the economy showed more vigor. Now the economy is slowing a bit, and some are wondering if it's a bit too soon for a rush back into housing stocks. Make no mistake: if the U.S. economy is weak as we head into 2013, it will be virtually impossible for the housing sector to deliver the growth that some anticipate.

At least that's the view of short sellers. They currently control roughly 41% of the float of home builder KB Home (NYSE: KBH). They may be focusing on the balance sheet, which carries more than $1.5 billion in debt. Management knows it must generate improving results to either lower that debt load or at least get bankers to help roll over debt as it comes due. Goldman Sachs, which rates the stock as "Neutral," notes that "at >75% net debt to capital, the issue of recapitalizing the balance sheet still remains a concern, in our view."

Analysts at Citigroup think KB Home may just be the proverbial worst house in the neighborhood: "Investors remain concerned that KBH is running low on economically viable lots, that its new mortgage partner relationship may not be picking up momentum quickly enough to restore order growth, and that growth and operating leverage may continue to lag peers." Their $8 price target represents roughly 25% downside.

Risks to Consider: A rising market often leads short sellers to cover their positions, which could fuel quick upside for these heavily-shorted stocks.

Action to Take --> Even as you seek out stocks with robust potential upside, you also need to commit time to finding overvalued stocks. A portfolio that is sprinkled with a few short positions can help blunt the pain of a falling market.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.