Is the market over-valued? In this week’s Outside the Box, one of my favorite global equity analyst’s (and no stranger to regular readers), James Montier of Societe Generale does some very interesting analysis on the European and US markets and finds the number of stocks which make his list as possible for being a “short” is at very high levels.

This is a remarkable read and re-enforces my view that we are in a “sell in May and go away” summer. This is really a great Outside the Box. Enjoy.

Joining the dark side

It never ceases to amaze me that whenever a major corporate declines the short sellers are suddenly painted as financial equivalents of psychopaths. This is madness, rather than examining the exceptionally poor (and sometimes criminal) decisions that the corporate itself took, the short sellers are hauled over the coals.

As the New York Times recently reminded us, vilifying short sellers is nothing new.

In the days when square-rigged galleons plied the spice route to the East, the Dutch outlawed a band of rebels that they feared might plunder their new-found riches.

The troublemakers were neither Barbary pirates nor Spanish spies — they were certain traders on the stock exchange in Amsterdam. Their offence: shorting the shares of the Dutch East India Company, purportedly the first company in the world to issue stock.

Short sellers, who sell assets like stocks in the hope that the price will fall, have been reviled ever since. England banned them for much of the 18th and 19th centuries. Napoleon deemed them enemies of the state. And Germany’s last Kaiser enlisted them to attack American markets (or so some Americans feared).

Jenny Anderson, NY Times, 30 April 2008

Last week, Albert Edwards took our equity weighting down to its minimum (see Global Strategy Weekly, 8 May 2008), and my own bottom-up valuation work finds little opportunity for investment at the moment (see Mind Matters, 28 January 2008). This suggests to me the main opportunities may lie on the short side in the current market. So I guess I am joining the ranks of the dark side!

This remains anathema to analysts. As the chart below shows the percentage of sell recommendations remains pathetically low. Indeed, the other day my head of research showed me the second chart below showing that SG had the highest percentage of sells amongst investment banks – it makes a pleasant change to see SG at the top of a list on a positive note!

All of this got me to thinking about how to identify potential short candidates. In keeping with my first note for SG (on limited information – see Mind Matters 3 December 2007, I want to focus on just a few key measures that stand out to me as sources of poor underperformance.

Valuation

Most obviously (and unsurprisingly given my value bias) one of my primary sources of underperformance has to be high valuation. There are myriad methods of valuing a stock, of course. However, from the perspective of a short seller, one of the most useful is price-to-sales.

Focusing upon high price-to-sales stocks allows us to hone in on story stocks – those stocks that have lost all touch with reality. During periods of investor enthusiasm there is often a marked tendency to move up the income statement in order to try and keep valuation multiples ‘low’. Indeed during the dotcom years, things were valued on measures such as average revenue per user, clicks and eyeballs!

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