Blue Nile: Color Me Skeptical

 | Sep 07, 2012 | 3:00 PM EDT  | Comments
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Stocks surged Thursday to multiyear highs on the back of the European Central Bank's announcement of a sovereign debt-buying program and better-than-expected economic reports. Stock indices closed approximately 2% higher across the board. Color me skeptical, but I am not a strong believer in this rally and I took the opportunity to move another 5% of my portfolio to cash on the close. I also instituted another short position on a soaring online retailer whose valuation is overstretched. There are three macro reasons for my skepticism.

First, regardless of this latest ECB program, the situation in Europe is grim. The continent has major structural problems that will take years to resolve, if they can be fixed at all. Spain is approaching 25% unemployment levels and it and Italy increasingly look like they will both need some sort of bailout in the next year. The fact remains that a good portion of Europe (Greece, Portugal, Italy, Spain) remains uncompetitive, is unwilling to make the structural changes needed to enable job growth, and does not have the ability to devalue its currency. Even Germany, which has been the main European growth engine, is starting to see its economy decelerate sharply.

Second, the Chinese economy and market is an off-the-radar story right now. Before today's bump, the Shanghai Index had hit multiyear lows in recent weeks. Chinese electricity usage also just came in with just over 1% growth year over year and iron ore prices have fallen more than 35% in the last few months, now at a three-year low, which reflects decelerating growth. Other commodities outside of precious metals have also had declines. Given China is one of the few remaining global growth engines, this is not an encouraging sign for the worldwide economy or for global markets.

Finally, nothing has been done domestically to resolve the looming "fiscal cliff," job and economic growth remain anemic, and business uncertainty remains high. Throw in rising gas prices and an election that will set new lows for negativity, the environment is likely to be highly volatile in coming months.

Although I am pessimistic about the outlook for the market and the worldwide economy overall, I am only making incremental moves here. Being right is one thing, getting the timing right is always the harder part of the equation. I fully expect I might be early and the rally might still have a few gasps of upside left. One reason is that money and hedge fund managers in general are significantly behind their benchmarks and are being forced to chase this rally. I have one leg out the door before the music stops for this dance. I am now approximately 50% long, 10% short with 40% in cash. With all these economic crosscurrents in mind, I added a short in global online diamond and fine jewelry retailer Blue Nile (NILE) on Thursday.

Four reasons NILE is significantly overvalued at $42 a share:

  • Twenty-five percent of the company's sales are from Europe, hardly a robust market for luxury jewelry.
  • Its main domestic market is engagement rings. Marriages are down 10% over the last decade, and given the unemployment rate among 18- to 29-year-olds, I doubt this trend will reverse anytime soon.
  • The stock sports a forward price-to-earnings ratio above 45 -- this for a company that has had negative earnings growth over the past five years and has raised sales about 5% annually over the same period.
  • Blue Nile has benefited from relatively low diamond prices (which are cyclical) and the company would be very vulnerable if calls for an online sales tax gains momentum. Insiders have sold more than 25% of their shares over the past six months, as well.

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