Juicy Odds for Picking Stocks That Could Plummet

July 14, 1999

IT HAS been almost a year to the day since the stock market went into a brief but steep decline, falling 20 percent in just six weeks and giving Wall Street its first whiff of real fear since the October 1987 crash.

Amid signs that equity shares are teetering even more precariously now with the market trading at all-time highs, it is probably a good time to pile up sandbags against the possible onslaught of another summer surprise.

Why should we worry?

For one, valuation levels are hitting extremes unseen since the early autumn of 1987, according to the technically savvy Amernick Letter, a weekly financial advisory based in Berkeley.

The proprietary model Larry Amernick uses to compare the earnings yield of the S&P 500 Index to 10-year Treasury notes has been flashing red for several months, indicating the index is 22.9 percent overvalued -- just a tad under the 23.8 percent figure registered in early October 1987.

Some of the technical indicators I use are similarly warning of lush over-ripeness in stock averages. One particular sentiment gauge suggests investors have never been more complacent during the 17-year run of this bull market.

At a time when mortgage rates have been creeping steadily higher for months, this is especially worrisome, since a further tightening could choke off the cheap housing money and home equity loans that have fed America's consumption boom and goosed the bull market in stocks.

If you don't believe a recession might be lurking around the bend, just ask the mine canary who has been shopping mortgages for the last month or two. He's already in a personal recession, mournful in a way that only a disapproving loan officer can make one mournful. Tack on another 50 basis points to the 30-year fixed, and we'll all be feeling his pain.

Let others wallow in despair, for there are effective ways to hedge a portfolio or even profit from a sharp decline in share prices. My strategy is fairly simple: Buy put options on those stocks that are likely to fall the hardest.

The buyer of a put is betting that a particular stock, index or futures contract will fall in price. Right now, for the reasons I have broached above, the betting odds are pretty good for bears.

Most of the stocks I've selected below are well regarded by mainstream analysts and some have even been touted recently as excellent buys. The combination of complacency and stupidity that underlies the analysts' reasoning will work to our advantage, since it has caused investors to shun put options, depressing their price.

Following are five stocks that are perched on the edge and which will likely pay fat odds if stock averages should fall:

IBM: At $132, Big Blue's shares currently trade around 37 times earnings -- a hefty premium for a company whose revenue growth has been negative since 1985 after adjusting for inflation. IBM's share price has increased twelvefold since 1994, but who'd believe that, during that time, sales growth averaged a paltry 5.6 percent?

Moreover, in 1985, when the computer maker's profit margins were higher and its growth far more robust, investors were willing to pay only 11 times earnings. Were they smarter back then? Or just not as greedy? Wall Street's wizards will wise up sooner or later, and when they do, the stock will fall by half. An added bonus for hedgers is that IBM is currently trading near all-time highs, never having corrected as much as 20 percent during the steepest part of this bull market.

Citigroup: Citi is widely regarded as the savviest and most sophisticated player in global banking. A cynic might say the company has simply found more ways than its ablest competitors to profit by cloning and manipulating grotesquely leveraged debt instruments.

Probably only a handful of numbers-crunchers outside of the securitized debt field understand exactly how they do it, but even Joe Sixpack knows there must be plenty of smoke and mirrors involved. This is apparent from the cathedral-shaped trajectory Citigroup shares trace out on the charts every time a major mood swing hits Wall Street.

A canny bear could have made $1,000 or more for every $25 invested in Citi put options last summer, when the stock fell from 48 to 19 in mere weeks. Is there anyone who thinks it could not happen again?

AMR: This is a double-your-pleasure bet, an opportunity to profit from the decline of a company whose gains have come mainly from inflicting larger and larger doses of misery and indignity on its passengers.

The airlines as a group are highly vulnerable to an economic downturn because there is no fat for them to cut: Seats could not be any narrower, meals more Spartan, or equipment more heavily used.

We read that, using sophisticated computer programs, airlines have mastered the art of filling every seat at the optimal price. It is evidently not a fine science, though, or transcontinental supersaver fares would not have snuck up so greedily on the $500 threshold last spring.

I've picked American over United in this category simply because the former's shares are trading much closer to all-time highs. Steer clear of Southwest and Frontier, though, because they seem to be getting it right.

Mirage: All successful casino companies have one thing in common: the unwavering belief that each and every American is a potential high-roller. With the construction of Bellagio -- at $1.6 billion, the most expensive casino on earth -- Mirage has seemingly bet all of its chips on that dubious premise.

Perhaps there will always be enough water in the Nevada desert to keep Bellagio's huge lake and its thousands of fountains flowing copiously. But it is probably farfetched to think there will be enough high-rollers to fill the resort's 3,000 rooms during the next economic downturn. Although the stock at $15 is trading 50 percent off recent highs, any rally above $20 should be viewed as an opportune short sale using the put-buying strategy that I have described.

Amazon.com: For about the last year or so the company's share price has traced out on the chart in what technical analysts call a head and shoulders formation. This is a very bearish pattern, and in Amazon's case it implies the stock will eventually fall to below $30 from a current $126 (which is itself down from an all-time high of $221). It's not hard to see why.

The company's core business of selling books has not made any money and may never do so, given the cutthroat competition that has emerged. Amazon has tried to expand into other areas of Web- based selling, but so has nearly everyone else. Five years from now, the firm will be a textbook case of how Internet mania on Wall Street got it all wrong.

If you decide to hedge your stock portfolio with put options on any of the above stocks, your annualized outlay for those puts should be no more than 10 percent of the value of the portfolio itself. Investors should check with their brokers to determine the suitability of using options as a hedge, since purchases are unmargined and losses can equal 100 percent of you investment.

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