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Short Selling the Recession

Written By Brian Hicks

Posted July 16, 2009

Despite the best efforts of the bulls, the ghost Jesse Livermore lives.

After being practically smothered to death a month ago, short selling bears have staged something of a comeback.

Livermore, of course, made a massive fortune betting against the markets. He went short the market in 1929, earning $100 million in short-selling profits along the way.

That big haul, though, was only a part of Livermore’s legend. He traded his way to riches back in the days when they still literally read the tape. Long or short, it didn’t matter to Jesse.  

Instead, he was happy to take whatever the markets gave him because he knew what every good trader knows: markets never go straight up or straight down.

That’s part of the logic that has the bears on the rise again this month, after a 42% bounce off of the March lows. In fact, bearish bets against the S&P 500 rose to their highest level since April last month as investors sold more shares short.

Additionally, short interest on the S&P 500 increased to 10.01 billion shares as of June 30, a gain of 2.4% from just two weeks earlier, as the "green shoots" arguments have turned limp in the face of more bad data.

"There’s just a lot of bearishness," James Paulsen of Wells Capital Management told Bloomberg recently. "It reflects the brutal recession we’re in. There’s a dominance of doubt and short interest is just a reflection of that."

Short Selling the Recession: A Set Up to the Downside

But double-digit unemployment, falling assets prices, and struggling consumers are only part of the bearish equation. Aside from the fundamentals, the markets are also technically weak.

Of course, for most investors, the idea of technical analysis only brings out one of two possible emotions — either they love it or they hate it.

But for those who swear by it, the lines on those charts are more than points on a graph. They are windows into a world where the price action of the past gives clues into the price action of the future.

Needless to say, that "crystal ball" type of approach to the markets leaves the non-believers simply shaking their heads.

One of them is actually a hero of mine named Warren Buffett. You may have heard of him. And while he’s known around the world as the "Oracle of Omaha," he has no use whatsoever for charts and their deeper meanings.

In fact, Buffet’s disdain of this type of tea-leaf reading is well known. "I realized technical analysis didn’t work," Buffett has said, "when I turned the charts upside down and didn’t get a different answer."

Even still, for a wide swath of investors, heading into the markets without their charts is simply unthinkable, and I am one of them.

And in that regard, part of what has the bears looking to press the downside these days is the ongoing formation on a reversal pattern known as a head and shoulders top.

But before I go on, I’d like to give you a quick education on the worrisome pattern.

So, What Does a Classic Head and Shoulders Top Look Like?

First, we’ll start with a current chart of the DOW because if (a big if) the pattern completes itself, it would likely spell the end of the March rally off the lows, reversing the trend.

Take a look:



As depicted above, the classic head and shoulders top looks like a human head with shoulders on either side of the head.

The first point — (1) the left shoulder — occurs as the price of the stock in a rising market hits a high and then falls back. The second point — (2) the head — happens when prices rise to an even higher high and then fall back again. The third point — (3) the right shoulder — occurs when prices move up again but don’t rise much above the high of the left shoulder.

The key to the pattern, however, is the neckline, which in this case is roughly 8150. That’s the mark the bears will be gunning for, since the pattern is complete when the support provided by the neckline is broken.

This occurs when the price of the stock, falling from the high point of the right shoulder, moves below the neckline. Technical analysts will often say the pattern is not confirmed until the price closes below the neckline — it is not enough for it to trade below the neckline.

Calculating the bearish downside target, then, is just a simple matter of the math. To figure it out, you subtract the high of the head (roughly 8800) by its distance from the neckline of 8150.

That gives you a figure of 650 points. Then, you subtract those same 650 points from the 8150 of the neckline to arrive at a target of 7500. That corresponds with a 787 figure on the S&P 500 and would likely mark the near-term bottom of the move, if it plays out according to the bearish playbook.

However, with an earnings surprise to the upside by Goldman Sachs, and Meredith Whitney’s predicting the "mother of all mortgage quarters," a near-term rally has put short sellers on edge, since a similar story squeezed them pretty hard in March.

To that end, short sellers will be keeping an eye on the 8600 mark on the Dow, since a break out on volume above those levels may force them to cover. Conversely, if resistance holds at 8600, it’s a positive for the bears, as the right shoulder completes the pattern.

Keep that in mind as you trade. It should be an epic battle.

So, what ever happened to Jesse L. Livermore?

He made and lost more fortunes than most traders can even contemplate. But he didn’t die a poor man by any stretch of the imagination.

He did, however, kill himself believing that he was "a failure," proving once again that money can’t buy happiness.

Of course, it certainly doesn’t hurt either.

Your bargain-hunting analyst,

steve sig

Steve Christ, Investment Director

The Wealth Advisory

By the way, this little tidbit was lost in all of the hoopla surrounding Goldman’s earnings this week. Despite earning $4.93 a share for the quarter, the company did book big losses in commercial real estate. Hidden beneath the trading revenue was a $700,000,000 loss in commercial real estate mortgage write downs. That’s an area shorts will jump on as the dominos begin to fall. To learn more about the brewing collapse in commercial real estate, click here.