What describes a "qualifying" stock for shorting?

...I was asked these series of questions today by a fellow member:

“I am your subscriber and I am wondering about your choices for a short? You wrote on Daily Screen for: 04/18/2005 “We do not recommend buying anything in the current market environment unless you are establishing a short position in a qualifying stock.”

What describes a "qualifying" stock for shorting?

Some stocks you mentioned have good fundamentals. Why would you like to short stocks with good fundamentals at all? Isn't it more logical to short stocks with weak fundamentals and weak technicals?”

To start, please read the two part series on shorting stocks in this blog to understand what the qualifying characteristics are for these types of stocks. These two very informative articles were written last month on March 16th and 18th.

Shorting Stocks – The Basics, Part I of II ...What does it mean to short a stock?
Shorting Stocks – The Basics, Part II of II

Now that you have read or re-read those two articles, I will now refer back to another great article that I wrote back on February 21, 2005, titled: Fundamentals are late to the Party.

In this article I said “A stock usually breaks down well before the actual fundamentals turn negative and official news hits the street. Insiders always start to sell when things are looking down or sales are not expanding. This poses a problem for the individual investor because they won't know about poor sales or earnings until the official news is published or the company changes their outlook in a conference call, months after the problem has already developed.”

This member is correct by asking the question about solid fundamentals but we all must remember that fundamentals will stay positive much longer than the technical indicators. Ideally, deteriorating fundamentals are preferred over superior fundamentals but it is not as important as we all would like to think. Leaders from six months ago are typically the stocks that will start to fail today (especially in the weak environment), setting up for nice profit opportunities using a shorting strategy. The charts will show us reversals, trend-lines breaking and moving averages being sliced. We also must remember that 75% of all stocks will follow the general trend of the major indices and that has been a pure sideways correction in 2005.

For example, EBAY still has solid earnings and sales but the stock price has dropped almost 50% since December and 33% over the past couple of months since placed on our Red Flag screens. The market is usually priced into a stock approximately six months in advance. The market anticipates what the stock will be doing six months from now and that is why you must use both fundamental and technical analysis when making decisions based on future movements. If you go back and see some of the best shorts of all time, their fundamentals were still great as they were breaking down and becoming prime short candidates.

The only way we can assess the direction of a stock is by the underlying trend that is established on the charts. We confirm these trends with volume because we know that only institutions can develop moves powerful enough to spike volume levels above average on a daily and weekly basis. What individual investor do you know that trades millions of shares a day, every day in eBay? No one! The institutions drove down eBay’s stock over the past 5 months based on future expectations and speculation of slowing sales. They were right and the stock dropped.

Recently I have screened the builder stocks as red flags even though their fundamentals are still superior. With recent drops below their 50-d moving averages and breakdowns on the point and figure charts, I calculated that something is changing within this industry. Since making our red flag screens last month, they have all recorded double digit losses. There are two reasons for this:
The market is very weak and the ‘M’ in CANSLIM is negative
The industry is boasting late stage bases while interest rates are rising and fears of inflation are growing.

If anyone has more questions on this subject, please post them to the comment link below on this blog article and this discussion and lesson will continue.

Piranha