During any market cycle, there will be leading and lagging sectors as well as industry groups within them. For bearish traders, the act of focusing on stocks in weak performing groups or sectors is one way to improve their probability of long-term success.
A sinking tide lowers all boats
Though this phrase has been used to describe the effect of a bear market in the broader market averages, it is perhaps more applicable when applied to the action of industry groups and the stocks within them. Historically, the market has shown that even the best companies struggle if their industry group is underperforming. While there will always be outliers, identifying an industry group that is performing poorly can be a good place from which to begin evaluating short selling candidates.
The effect of fundamental changes within an industry group
Business conditions can change quickly for any company or industry, often based on unforeseen events or circumstances. However, meaningful changes in the underlying fundamentals for an industry will often play out over a long period of time. If demand for the products and services offered by a given industry decreases, there is the potential for a long, sustained downtrend in performance by the overall industry in question. For example, if the traditional shoelace was phased out in favor of Velcro, while it might take a long period to happen, there would be a visible decrease in demand for shoelaces as more and more Velcro shoes come to market.
The first phase of this change in conditions might involve a few astute investors who recognize early on that the outlook for an industry is about to worsen. Slowly, the stocks of the companies in the industry group start to decline. After a while, more investors who track price movements, (rather than fundamentals), begin to recognize that a high percentage of companies in this industry are underperforming. This leads them to analyze the industry more closely and some will consider selling short shares of those companies.
Soon thereafter it becomes more widely recognized that this industry is experiencing poor performance, both in terms of business fundamentals and declining stock prices. Next, the companies in the industry begin to announce quarterly earnings and sales and some of these announcements may involve negative earnings surprises. These negative announcements may attract more fundamental traders as they begin to recognize that some very unfavorable developments are taking place within the industry.
Eventually, prices for stocks in the industry decline enough to qualify the industry as a weak performer relative to other industry groups. This can lead to more stock holders deciding it is time to sell their shares. This can add to selling pressure and drives the price even lower. At first, the selling may be focused on those companies that are perceived to be the weakest in the industry. However, once those stocks have been beaten down, many traders will begin to look at other stocks within the industry group in hopes of finding others that may still be due for a fall.
The process described above can take from several months to several years, (or more), to play out. In general, the more significant the negative change in fundamentals, the longer the process will take to transpire. For this reason, it can be useful to look at industry group performance to see just how long a weak group has been performing poorly. If the fundamentals are weak and especially if the overall market is in a downtrend, a down-trending group can continue to fall for an extended period. For this reason, some traders will apply trend-following techniques, such as moving averages, to industry group action in order to keep themselves on the right side of price movement for as long as possible.
In addition to the direction and longevity of the trend, traders are also interested in the actual magnitude of price movements within an industry group. Certain groups, such as technology and biotechnology, are historically prone to volatility. As noted earlier, sometimes – especially when the overall market is in a downtrend - a good way to find an industry group that will under-perform the market going forward is to find an industry group that has already been performing poorly of late.
One word of caution: Within a severe price decline, upside price reversals can be swift and large in percentage. Even though they may not last very long, they can be large enough to cause a bearish trader to exit a short position prematurely. For this reason, attempting to sell short in the face of a sharp decline should be considered a potentially profitable, but very high risk endeavor.
Looking at stocks within an industry group
Once a trader identifies what they consider to be a weak industry group, there are several potential strategies to consider. One approach is to sell short a variety of stocks within the group in order to hold a position that reflects the action of the overall group rather than just an individual company. A second possibility for aggressive traders is to focus on the worst performing companies within the group in hopes of maximizing their returns. Another possible strategy is to sell short a sector or industry ETF. This choice allows a trader the potential to participate in a bearish movement of a sector or industry without having to select which individual stocks to sell short.
An old investment adage states that “it is not a stock market, but a market of stocks.” The point of this statement is that stock traders must ultimately select individual stocks to buy or sell short in order to succeed. However, it can also be stated that “it is a market of industries”, with any number of companies competing within a particular industry.
Considering which industries are performing poorly and are likely to continue performing poorly can be an appropriate place for bearish traders to start when looking for individual stocks to sell short.