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  1. Home
  2. / Investing
  3. / Consumer Discretionary

Time to Protect Your Downside

Stocks have not really fallen very far, and we're still at risk of slipping further.
By TIM MELVIN May 30, 2012 | 02:00 PM EDT
Stocks quotes in this article: AVB, LULU, UA

This "huge" selloff of the past month really is not all that big. Investors and traders have been talking about it as if it were a huge buying opportunity or the start of the end of the world, depending on their mind-set and bias. It really has not been either, as the stock market has not even declined 10% off the highs so far.

It is not time to hobble down to Wall Street and load up on cheap stocks. Nor is it time to sell the safe and cheap stocks you currently hold in your portfolio. No one knows which way the market will trade for the rest of the year, and those pundits who get the direction correct will merely be lucky, not prescient or skillful prognosticators.

Despite all the noise, stocks have not fallen that much in the past month or so. However, let's acknowledge that the risks are very real that we could see a much larger selloff. All the fuel for the fire is in place, just waiting for a torch. Everything out of Europe borders on full-on disaster. Spain and Italy are straining to right their fiscal ships. Greece and Portugal are probably just sunk at this point. Ireland's successful bailout appears to be springing a leak.

It is not all pretty little flowers here in the U.S. markets either. Big momentum names, including previous leaders Green Mountain Coffee Roasters (GMCR) and Netflix (NFLX), have rolled over and crashed. I have no opinion on what happens to Facebook (FB), now that the IPO has busted, but the trading in the stock contains valuable information about retail participation and belief in this market. The U.S. 10-year yield at 1.66% is not predicting wonderful things for the economy in the second half of the year. Thoughtful investors have to consider the possibility of falling off an economic cliff as spending cuts and tax increases kick in next year.

Given that there is a significant chance that the bad news leads us lower, there are some sectors and stocks I would avoid and even consider shorting outright on strength (using the put-spread chicken approach, of course). I have talked in the past about the apartment REITs such as AvalonBay Communities (AVB), Essex Property Trust (ESS) and Equity Residential (EQR). I am well aware that apartments are in an economic sweet spot in the aftermath of the housing crisis, but the valuations are far beyond what a rational buyer would pay for the underlying properties. Money will eventually move out of this sector, and prices will decline rather rapidly, in my opinion. The risk is not worth the limited reward of owning these large REITs.

I am also skeptical that some of the red-hot specialty retailers can maintain their valuations if the economy begins to fall off once again. I confess that I have been dead wrong on lululemon athletica (LULU) so far, but its valuation just does not seem sustainable to me. Admittedly, I am an old guy and will likely never wander into one of their stores expect by mistake, but no matter how much the non-curmudgeonly population likes yoga clothing, an earnings multiple of almost 60 is just too high. One missed estimate or lowered opinion, and this stock could fall substantially and quickly.

It pains me to have to say the same thing about Under Armour (UA). These are genuine corporate good guys who have done great things in the community here in Baltimore. I have never worn their product, but I am told they make outstanding clothing and athletic footwear. However, its stock is at the upper end of the price points in the market and will be the first to suffer if the economy gets any weaker. I also note heavy insider selling in the stock in recent weeks. The potential downside is far greater than the remaining upside, in my opinion.

No one can tell you with any certainty which way this market will go. If you focus on safe and cheap, avoid the high-multiple stocks and hold cash, you are positioned to win whatever happens.

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At the time of publication, Melvin had no positions in stocks mentioned.

TAGS: Investing | U.S. Equity | Consumer Discretionary | Stocks

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