Two Timely Shorts

The Oxford Hedge Trader
Thursday, August 31, 2006
By Louis Basenese

Email – #1

** Two Timely Shorts

I want to first extend a warm welcome to all of you as new subscribers to the Oxford Hedge Trader. And let me assure you, given our flexible investment strategy, I have nothing but high performance expectations for this service.

So let’s not waste any time in setting up our portfolio.

Today, we’ll add two short picks. Then early next week, we’ll balance the portfolio out with two long ones, providing us with a strong base to expand upon in future weeks.

Expecting Real Estate to Go From Cool to Ice Cold

No one’s denying the housing market is cooling off. But the world’s top hedge funds are making a much stronger statement.

As one manager put it, “the nasty correction in real estate has far from run its course.”

Backing up this bravado are huge sums of money. In the past year alone, at least $100 billion in hedge fund capital poured into bets against housing… some in complicated and newly created credit-default swaps. And the bulk in straightforward short selling.

In fact, thanks to hedge funds, short interest in the most recognized real estate ETFs is near record levels.

With that being said, we shouldn’t be fooled into thinking the Fed’s recent pause will salvage the housing boom. Investor sentiment is a slow-moving beast when it comes to the real estate industry. And a measly pause is hardly enough to turn the tide.

A quick glance at the table below suggests nothing shy of a precipitous drop in interest rates could turn this market around. And based on the Fed notes released Tuesday, such a move is not even a consideration.

So how do we play this trend?

By shorting Pulte Homes (NYSE: PHM) – one of the nation’s largest home builders. Order volumes are dropping by double-digit margins. Cancellation rates are near 30% (roughly 10 points higher than the historical average). And management keeps slashing expectations moving forward.

Masking the true problems, though, are countless incentives being used to prop up average selling prices. Once buyers stop taking the bait – of no closing costs, free upgrades, pre-paid homeowner’s dues, etc. – expect average selling prices to nose-dive, too.

And when that happens, the results will be much more disappointing than last quarter’s 20% slump in profits and 12% slip in backlog.

Even management is reeling to figure out where the bottom will be. “How bad will it get and how long will it last?” management asked in a recent conference call. “No one can answer these questions with any degree of certainty.”

Translation: Even management knows the worst is far from over.

Action to Take: Sell short Pulte Homes (NYSE: PHM) at market and place a buy stop at $35.25 for protection. Speculators might want to consider the January 2007 $25 puts (PHM-ME), but don’t pay more than $1.50.

Waiting for the Consumer to Scream Uncle

For too long, the Street has been amazed by the resiliency of the American consumer to keep spending. Gas prices are high, wages are barely increasing and yet we just can’t stop buying $4 lattes and $200 pairs of jeans.

Rest assured we’re nearing a breaking point.

Remember, the U.S. has an effective savings rate of 0%. So beyond monthly paychecks, most of the funding for this irrational spending is coming from credit cards and cash out refinances. With interest rates much higher than they were a year ago and lending requirements tightening, these two sources of easy cash will be less attractive. Plus, minimum payments will be that much higher.

Look for the slowdown to hit higher end retailers first. Places where Americans spend money they don’t have, to buy things they don’t need, to impress people they don’t like. A prime example, being Saks Inc. (NYSE: SKS).

Led by a revolving door of management teams, the company is struggling. Same-store sales are negative for the year and operating expenses are increasing. Of course, none of this is new.

Over the past five years, Saks has been at the bottom of its industry in terms of profitability and operating margins. Even worse, the company’s been unable to earn a return on investment greater than its cost of capital.

All the while, shares still trade at a premium to industry peers based on forward earnings. Hardly a deserving valuation. And that’s something even the insiders conceded this month as they decided to unload more than 2 million shares.

Action to Take: Sell short Saks, Inc. (NYSE: SKS) at market and place a buy stop at $17.25 for protection. Speculators might want to consider the January 2007 $13.50 puts (SKS-MP), but don’t pay more than $1.

Enjoy the long weekend and expect your next alert on Tuesday or Wednesday of next week.

Good investing,

Louis Basenese

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