Short-Selling with the O'Neil Disciples. Morales Gil

crisis that would shake the financial market three years later.

      Source: Chart courtesy of HGSI Investment Software, LLC (www.highgrowthstock.com), ©2014.

Figure 1.2 Pulte Group (PHM) weekly chart, 2003–2007. This builder of single-family homes, townhouses, condominiums, and duplexes in 28 states had a nearly tenfold price move from 2000 to midsummer 2005.

      Source: Chart courtesy of HGSI Investment Software, LLC (www.highgrowthstock.com), ©2014.

      Homebuilding stocks to a large extent represented the point at which the rubber meets the road for the financial crisis as the consumer “end-product” of the housing stimulus, provided by an extremely low interest rate environment and lax lending standards both mandated and promoted by government policies that were readily embraced by the home-loan industry. As more and more consumers purchased homes they could not afford, eventually the chickens began to come home to roost as the reality of making loan payments took hold. The stock market, in its inimitable ability to foresee and begin discounting the future, saw this coming, and when the homebuilding stocks topped, they represented the first warning shot across the bow for the homebuilding industry at large, including the financiers and suppliers that both fed it and fed off of it. In this manner, the top in homebuilding stocks represented stage one of the impending financial crisis.

The great bear market of 2007–2009 officially started when the major market indexes topped in October 2007. Figure 1.3 shows the NASDAQ Composite Index topping in late October 2007 and then moving sideways for six weeks before breaking down further in January of 2008. The observant reader might also note that around this time the NASDAQ Composite had formed something of a “head and shoulders” top formation, a pattern that we will examine in detail later on in this book.

Figure 1.3 NASDAQ Composite Index, weekly chart 2006–2009. The general stock market, as represented by the NASDAQ Composite Index, tops in late October 2007.

      Source: Chart courtesy of HGSI Investment Software, LLC (www.highgrowthstock.com), ©2014.

While the general market did not top until October of 2007, we have already observed that the homebuilding stocks topped in July of 2005, more than two years prior to the general market top in 2007. That was the first warning shot across the bow, but the second warning shot took place in the financial stocks themselves when they began to top in May of 2007, preceding the general market top by exactly five months. The chart of the Financial Select Sector SPDR (XLF), shown on a weekly chart in Figure 1.4, shows a classic head and shoulders topping formation around the peak in May 2007.

Figure 1.4 The financial sector, as measured by the Financial Select Sector SPDR (XLF) ETF, tops in May of 2007, well before the general market indexes and long before the actual financial crisis took hold in the fall of 2008.

      Source: Chart courtesy of HGSI Investment Software, LLC (www.highgrowthstock.com), ©2014.

The breakdown in the peak off the top in the financial sector constituting the first down leg in the XLF took place from May to August, at which point the XLF rallied twice back up to its 40-week moving average. As financials led the downturn off the peak in May 2007, the period from August to October produced volatile reaction rallies and bounces in the group as a number of other leading groups, including solar energy stocks like First Solar (FSLR), shown in Figure 1.5, and Sunpower Corp. (SPWR), and technology stocks like Apple (AAPL), shown in Figure 1.6, and Baidu (BIDU) continued to rally well past the general market top in October 2007 and into late December 2007 and early January 2008.

Figure 1.5 First Solar (FSLR) weekly chart, 2007–2008. Notice that FSLR initially tops out in late December 2007, and is then able to rally back to new highs when the general market stages a reaction rally and puts in a final top later in 2008, as the third and final leg of the 2008–2009 bear market takes hold.

      Source: Chart courtesy of HGSI Investment Software, LLC (www.highgrowthstock.com), ©2014.

Figure 1.6 Apple (AAPL) weekly chart, 2007–2008. Notice that AAPL does not top out until early January 2008, over two months after the general market tops.

      Source: Chart courtesy of HGSI Investment Software, LLC (www.highgrowthstock.com), ©2014.

      So as the general market was continuing to move higher from May to October, the financials were trying to bounce and rally with the market, but this action only served to create a right shoulder in an overall head and shoulders top in the XLF, which then broke down in synchrony with the actual general market top in October 2007, as illustrated by the weekly chart of the XLF in Figure 1.4. Once the general market topped in October 2007, the other areas of leadership during the bull phase started to top over the next few months as a final wave of topping leaders took hold in early 2008, resulting in the second leg down off the peak in the NASDAQ Composite Index in January 2008, as can be seen in Figure 1.3.

      The lesson here is that bear markets and the short-selling opportunities they present are thematic, unfolding events that reflect what is going on in the general economy – essentially, the “underlying conditions” that the great trader Jesse Livermore described as the backdrop of any market trend, whether bull or bear. Before the bear market becomes obvious to everyone, including government officials, stocks are already starting to top in waves, as money that had moved in during the uptrend now seeks to exit the market and leading stocks. This is a natural process and is in no way, shape, or form something that is artificially created by short-sellers.

      Very real excesses build up in any bull market phase, which is often propelled by underlying growth in specific areas of the economy. In the early- to mid-1990s we saw a strong bull phase that was generated by strong growth in the technology area, specifically semiconductors and related computer technology, as the PC boom took root. In the late 1990s it was growth in the potential and profitability of the Internet that drove the wild dot.com boom, which in turn drove a parabolic bull market. In the mid-2000s, the bull market that ended in October 2007 was helped along by a housing bubble that resulted from excesses in easy money policies. Easy money policies by the Fed also served to sharply devalue the U.S. dollar, leading to huge growth in the prices of “stuff” stocks – companies that mined or produced basic materials such as steel, precious metals, fertilizers, coal, and building materials.

      The ensuing bear markets are nothing more than the natural clearing out of excesses that were built up in the prior bull phases as winners and losers are sorted out and the foundation is laid for the next growth phase. Short-sellers are merely smart investors who can recognize a change in trend in the general market and leading stocks and profit thereby. If the stock market is accepted by all as a way to build wealth, why shouldn't investors also be able to take action to protect that wealth during a bear market, and even seek to further build that wealth by profiting on the short side? In our view, short-selling is as American as baseball, Mom, and apple pie.

      How Not to Sell Stocks Short

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