Imagine for a moment that at the end of 2022, you made the decision to take a month off from the stock market.
You’d had enough of the frustrations that bear markets always bring. You simply wanted to clear your head, vowing to reassess the state of the markets at the end of January.
So, now, a couple of days into February … you have a look at what stocks have done during your January hiatus.
And you’re mortified.
Carnival (CCL) cruised 34% higher in January…
The real estate platform Zillow (Z) gained 38%…
Tesla (TSLA) pulled a U-turn and is up 40%…
Peloton (PTON) found its legs and is up 63% (!)…
Wayfair (W) is up 84%…
And, gosh darn it, that Carvana (CVNA) stock everyone was absolutely trashing at year’s end … the thing is up 115% in January alone.
So now you’re thinking…
“That was the worst decision I’ve ever made. Everyone made money last month and I made nothing.”
“With gains like those, it must mean the bull market has started without me.”
“I must get in … like, today … or I’m going to miss out!”
I wouldn’t blame you for thinking this way. But, as I see it, you’d be wrong.
See, I’ve looked at the 35 best-performing stocks in January.
They produced gains ranging from 33% to 115%, with an average of 50%. Impressive, no doubt.
The thing is, they all share one thing in common: January’s top performers were among the group of stocks that did the absolute worst in 2022.
Carnival (CCL) may have gained 34% in January … but that was after losing 60% in 2022.
Zillow (Z) bounced 38% in January … after a steep 50% loss last year.
Tesla (TSLA) shares gained 40% in January … after losing 65%, worth more than $670 billion in market cap last year!
Peloton (PTON) was down a whopping 78% in 2022.
Wayfair (W) sank 83% last year.
And Carvana (CVNA), of course, lost 98% of its value in 2022.
Considering all this, I want to arm you with a critical insight as you begin to think about what to expect (and do) over the next 11 months…
It’s a “Fake Out” Rally
Plainly, these rallies are not to be trusted.
If you think you should buy shares of Tesla (TSLA) just because the stock was up 40% in January…
Or that you should buy Carvana (CVNA) after its 115% surge…
You are far more likely to be the “sucker” of those moves than the benefactor.
See, there’s a simple explanation for how an enticing rally in the market’s “worst” stocks happens in the first place…
It’s called “short covering.”
Let me explain…
When someone feels that a stock’s price is unjustly and unsustainably too high, they can make a trade that will benefit if the stock price falls.
We call this “shorting” the stock.
To do that, you must complete the following steps:
- Ask your broker to “borrow” shares of the stock, since you don’t own it.
- Sell the shares you borrowed in the open market, for the price you feel is “too high.”
- Wait for the stock to drop lower in price.
- Buy back shares of the stock in the open market, pocketing your profits.
- Return those shares to the broker who lent them to you.
(If it sounds a bit complicated, don’t worry — I personally know of a far easier and better way to bet on the decline of a company’s stock. Look forward to next week for more details.)
There are tons of people out there — often very large and sophisticated hedge funds — who “sell short” shares of a company’s stock, aiming to make a big profit on its downfall.
And there’s only one thing you need to understand about the five short selling steps I outlined above: Short sellers must buy shares of the stock … to close their trades.
So when a bunch of people amass large “short” positions in a stock like Carvana…
Or in a stock that for some reason has traded to a nose-bleed valuation of 1,103-times earnings, as Tesla’s stock did recently (insanity!)…
And then the stock goes down, giving those short sellers massive “open” profits…
To lock in those profits … short sellers must begin buying shares of the stock.
Again, they aren’t buying shares because they think the stock is a good long-term investment … nor because they think a new bull market is getting underway.
They’re simply buying shares to close out their profitable short positions.
This scenario of course makes the price of the stock go higher for some time. Each short seller sees the price of the stock creeping higher and, in an effort to not allow his profits to erode away, he becomes willing to buy back his short position at increasingly higher prices.
This creates what we call a “short-covering rally,” since the rally is being driven by short sellers who are covering (aka closing) their positions. Not by “real,” bullish, long-term investors.
Energy stocks in a “Super Bull,” and this stock could 10X in the next 100 days.
So, that’s the first mechanism that can create strong-looking, short-term rallies in stocks that were previously beat down.
It’s not a bullish signal … it’s a bearish one because the “real” buyers aren’t actually involved.
What You Should Expect (and Do) in 2023
At this point, I hope I’ve at least opened your eyes to the role short sellers can play in the market … and why the January rally is not to be trusted.
But my job here isn’t to leave you with worry or doubt. My job is to help you know what to do in any market environment, even when the precise timing of the market’s next major trend isn’t crystal clear.
(Psst, it rarely is — investing is an endeavor of decision-making under uncertainty.)
To be clear, I’m most certainly not a “permabear.”
I’m a cautious optimist, and I’ve helped thousands of my readers find great success on the bullish side of the market.
I’d also call myself a “realist.” And sometimes, that means making opportunistic trades on fundamentally flawed stocks … or, more simply, ones that are grossly overvalued and almost sure to fall back down to earth.
Last year, for instance, in my Max Profit Alert service…
- 9 out of 11 of our closing trades on bullish positions were profitable, and…
- 9 out of 9 of our closing trades on bearish (aka “short”) positions were profitable.
Again, I mentioned above how I use a method of “shorting” a stock that’s far easier and safer than the five steps I described above. And last year alone, it allowed us to lock in gains of between 69% and 182% — all benefiting from declines in the prices of stocks that my system and I identified as unjustly and unsustainably “too high.”
This year, I plan to take the same “balanced” approach between bullish and bearish opportunities.
I know there will be plenty of opportunities to make good money on the long side of the right stocks, as there almost always are.
And, after seeing the kind of stocks that rallied in January… I’m mapping out a battle plan for helping my subscribers profit from a “lower for longer” bear market that could chop another 40% to 80% off the price of the market’s most vulnerable stocks.
That battle plan involves something similar to what the short sellers do … but with no risk of a short squeeze.
Tune in next week, and I’ll share a bit about my top target.
It’s controversial to say the least. You’ve definitely heard of it before, and almost certainly have exposure to in your portfolio. And it happens to be one among the many “fake out rallies” we saw in January.
Until next week, just be wary of chasing any rallies in stocks that had a poor 2022. We are not seeing a sea change in fundamentals here. These stocks are down for a reason … and I don’t want you to get trapped in them.
Regards,
Adam O’DellChief Investment Strategist, Money & Markets
P.S. There’s a whole class of stocks that did VERY well in 2022… And for the right reasons…
Oil and energy stocks.
I believe the sector is setting up for a once-in-a-lifetime Super Bull that’ll take oil prices higher than anyone thinks possible.
Prices are off their local highs right now. That doesn’t change my conviction that the bull market in this sector has barely just begun.
Full details — including how you can learn my top oil pick — right here.
This quote comes from Daniel Drew, notorious swashbuckler from the early days of Wall Street.
I was thinking about these words as I read Adam’s piece for today…
Adam isn’t alone in noticing the rally in garbage stocks. I’ve been watching the rally in Carvana … and alternating between amusement and disgust.
It’s funny to watch a company with no viable business model or path to profitability triple in value in a month. But then I consider the inexperienced investors that will likely get burned when the stock comes back down to earth … and it’s not so funny anymore.
Adam delved into the mechanics of short selling and how every share sold short is a share that must eventually be bought back. Short-covering rallies can turn into legitimate short squeezes when they get extreme enough.
You’re familiar with panic selling. During market panics, the buyers evaporate and the sellers trip over themselves trying to get out the door first.
Well, in a short squeeze, it’s the same scenario in reverse. The sellers evaporate, convert into forced buyers and trip over each other trying to buy the stock first.
When you own a stock that is performing poorly, you don’t have to sell it. You have the flexibility to hold it and wait for a better price if that makes sense.
But short sellers don’t have that option. Short selling requires margin … and has theoretical unlimited downside. Your broker won’t allow you to simply wait it out, either. You’ll face a margin call, where your options are either pony up more cash to cover the losses or scramble to buy shares to close out the short.
We have a little experience with this…
Back in 2021 when I was working closely with Adam in Green Zone Fortunes, we recommended the shares of National Beverage (FIZZ), the maker of sparkling water brand La Croix. Among our reasons for picking the stock was the massively high short interest. National Beverage was largely hated by Wall Street at the time, and we knew there was a good chance we’d see a short squeeze.
Well … we did! That was just before the epic short squeeze in GameStop (GME). Our position in National Beverage shot up over 100% in less than a month.
I love this stuff. And on Monday, I’ll be chatting with Adam and the gang on the Banyan Edge Podcast about short selling … short squeezes … and what exactly is happening with that dumpster fire of a stock Carvana!
Charles SizemoreChief Editor, The Banyan Edge
