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Stocks to Short for the Recession

Tuesday, November 13, 2007 | Ethan Roberts

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Editor's Note:  Today's article was submitted on our website by Tycoon Report reader and frequent contributor Ethan Roberts.  Please be sure to let him know what you think by clicking "Post a Comment" below and leaving your feedback!

A recent Tycoon article asked members what they would invest in during a bear market.  That sparked some very interesting and good answers.  Readers talked about gold and defensive stocks and bonds, strong fundamentals, value stocks, etc.

As another alternative, I would like to discuss shorting stocks that are likely to suffer the most during a recession.  I like shorting because stocks can go down faster and harder than they go up.  If you are on the right side of a shorting trade, you can make a lot of money in a (forgive the pun) "short" period of time.

One thing to remember is that Wall Street always looks ahead several months.  Stocks often drop precipitously BEFORE the recession arrives.  So if you believe we will be in recession six months from now, then now is the time to short stocks, not in six or twelve months.  In fact, many stocks will begin to rise well before the recession ends.  People are often amazed at how stocks can be going up when the economy is in such a bad state.  That is because Wall Street is seeing ahead to a time when the recession has ended.

Is a recession coming?  That is the key question.  I believe it is.  Recent bearish events in the real estate markets have predictably spilled over into the stock market and have caused massive declines in the financials (Countrywide, Washington Mutual, Citigroup), retailers (Lowe's, WalMart), and most recently, the tech stocks (Cisco).

It was only a matter of time before a Real Estate crash caused a ripple effect upon the stock market.  When people have a hard time paying their mortgage, there is little money left over to be spent on luxury goods and services.  If people lose their jobs, the first thing they do is stop spending.  Think about all the people whose work is related to the housing industry, and who have either lost their jobs or are now working only limited hours.

There are tradesmen (carpenters, plumbers, painters, electricians, etc), new home salespersons, title companies, attorneys, home inspectors, surveyors, and appraisers, all of whom depend on real estate sales.  And of course, you have mortgage and real estate companies and all of their staff.  Massive cuts at Countrywide and other lenders have been well documented.  So there are thousands of people whose livelihood has been eliminated or reduced, and who will now be spending far less money in an effort to survive.

So where do we look for candidates to short? Think about those things that are NOT essential products and services.  Start with the specialty retailers, the fancy restaurants, and the travel related stocks.  These are all sectors that cater to people spending discretionary money during good economic times.  But in bad times, people stay away, and the earnings of these companies can suffer.  Bad earnings = Lower stock prices.

My short list of shorts (again, no pun intended) might begin with stocks such as Coach, Pier One, Darden Restaurants, Ruth Chris Steakhouse, Starbucks, and Starwood Hotels.  Who needs expensive handbags and $5 coffee when the economy is under water?  Businesses will curtail travel, and families will forgo vacations and start eating more at home.

There are many other companies in these industries you can investigate.  I like to analyze charts of multiple stocks within the same industry.  The weakest stocks during the time when the market was rising will probably be the ones to fall the most in anticipation of a recession.

Caveat:  These stocks represent my opinion only.  Do your own research before investing.  Shorting is speculative, so do not use money you cannot afford to lose.  Always remember to use stop limit orders to cover your short positions.

For those who do not like shorting, an alternative is to buy the Exchange Traded Funds that short the major indexes or particular sectors.  ETFs such as the QID, which shorts the Nasdaq 100, or DOG, which shorts the Dow 30, are two that come to mind.  These can be bought in the same way that you would buy a stock.

We all hate to see a recession and falling stock markets, but shorting individual stocks and buying an ETF that shorts the market are two ways that you can still profit during a recessionary period.

I would also like to hear from other people about stocks you think would be good shorting candidates if the recession comes.

-- Ethan Roberts



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Ethan Roberts
Contributing Editor
The Tycoon Report




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45 Comments

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  4. HYPER a (1 year ago) Is this Spam?

    hi

  5. Sharon (1 year ago) Is this Spam?

    Hi Ethan,

    See your point. Starbucks expanded to soon and to fast. In the area where I live, there are 3 stores within 1/2 mile of each other, 2 of which are just down the walkway in the mall. The other just across the street from the mall entrance. And, then, there is another just 5 miles from the mall. Probably won't be long before there will be another just down to the corner.

    Starbucks, PapaJohns, grocery chains, subshops and just about every big chain, is starting the cocooning that was predicted back in the early 90s.

    Best,

    Sharon

  6. Ethan R (1 year ago) Is this Spam?

    Sharon:



    Thanks for the tip. But I don't think that means that Starbucks will make a lot more money if McDonalds sells more specialty coffee.



    Here is my reasoning. Let's say I run a lemonade stand on Main street. I charge a dollar per cup. In a year's time, I sell 2000 cups, so my gross sales are $2000. Now you decide to open up a lemonade stand on Easy Street, but you sell your cups for 75 cents.



    Over the next year, say that I lose 20% of my business to you, as word gets out that your lemonade is just as good, but much less (25%) expensive. So that year, I only sell 1600 cups of lemonade, and I make $1600 instead of my usual $2000.



    Now, for the lemonade that I sell you to make those 400 cups, I charge you 30 cents per cup. So I make back an additional $120. That means my total gross sales become $1720. I am still off $280 from what I used to sell before you opened your stand. And that is a 14% decline.



    Granted, I can manipulate these different numbers to make my case, but it seems to me that like McDonald's, you would not pay any more than 30 cents per cup, or your profit margin would be too small. In fact, you might even negotiate a lower price than 30 cents.



    So my point is that the additional money that Starbucks makes from selling to McDonald's could make up for some of the loss, but I think that overall, Starbucks loss of revenue could be greater than what they gain from selling to MCD.



    In fact, MCD was telling analysts the other day that they plan to really augment their breakfast menu, along with the specialty coffee that they will serve. So I think that an increase in their revenues could partially be at SBUX expense.



    Ok, one flaw I just noticed to my argument: SBUX will sell MCD more coffee than just the 20% of sales that they might lose to MCD. In other words, many customers who would never go to SBUX anyway, will still buy coffee from MCD.



    However, let's not forget that SBUX sells additional items besides coffee, like expensive muffins, cakes, etc., and that by going to MCD, people will not be buying those items at SBUX either. So sales on baked goods will be off too, unless SBUX is also planning on selling those items to MCD!



    So I think the loss from the other items could offset the additional revenue from the coffee that SBUX sells to MCD.



    At any rate, I think SBUX management is a bit afraid right now, and that their announcement to start advertising on TV, something they are usually reluctant to do, shows their concern for loss of sales.



    It was interesting to see the stock bounce back from the opening of 21.87 the other day, when it was down about 9%. Soon after, it hit a 52 week low of 21.77. By the end of the day, it was only down 3.8% to 23.17, still a significant drop, but certainly not as bad. A close below 22.57 will continue the bearish trend.

  7. Sharon (1 year ago) Is this Spam?

    Hi Ethan,

    A word about Starbucks, have two grandsons that are working at Starbucks as their part-time jobs while in college. So, with a little bit of inside information, McDonald's buys their fancy coffee from Starbucks. Albeit at a cheaper price.

    Best and see you at the TOP!

    Sharon

  8. Ethan R (1 year ago) Is this Spam?

    Starbucks (SBUX) is down 8% in the pre-market this morning, following an earnings report that met analyst expectations, but with lowered guidance for the upcoming fiscal year. The company cited softer consumer spending ahead, increased competitive pressure (e.g McDonalds to begin selling fancy coffee drinks for about two dollars less than Starbucks), and rising commodity costs.



    I stand by my prediction on this one. In bad times, consumers will not belly up to the coffee bar for $5 latte. I think they will be lining up in McDonald's or even Dunkin Donuts to get the same addiction "kick", but at a lower price.

  9. jdnam (1 year ago) Is this Spam?

    I suggest another choice for a bear market, since shorting can get really ugly if your wrong. I prefer a good mix of: 1)money market, convertible securities, preferred stock, long bonds, and intermediate bonds.

  10. lorenzo (1 year ago) Is this Spam?

    Mr Robert is too inform to be a semple subscriber

    of Tycoon, the rest of us have looong way to reach

    is level,good for you any ways Mr Robert.

    brevelore

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