It's funny to think that financial stocks were once the big driver of the equity bull market. Now they're acting more like a millstone around the market's neck.

The latest casualty is the two mortgage giants, Fannie Mae (FNM:NYSE) and Freddie Mac (FRE:NYSE). Both plunged to their lowest levels in 14 years yesterday, on fears they would have to raise massive amounts of new capital. This means trouble on Main Street and more housing market weakness as mortgage loans get even harder to come by.

But when the going gets tough, the tough get short -- one of the few attractive ways to play a market like this one. Cash McDash shares a trading idea this week that indirectly benefits from belt tightening and the mortgage mess. Take a look.

Warm Regards,

JL

 

JL: Well, it's finally official. The new service, IPO Confidential, is up and running, giving you a chance to share those exclusive picks with a smaller group of readers.

CASH: Yeah, the setup there makes me feel much more comfortable. I know that I can pass the best trades on to you, and Taipan will make sure to keep everything discreet.

JL: Your secret is safe with us.

CASH: Good. I don't want this to get out to more than a select group of readers. After all, it's pretty sensitive information. I'm excited about the three picks we laid out in the first brown envelope. Each of them has really been set up for some incredible gains. And this week, I've got another short idea that just started breaking down this past week. It's brand new, and in this market I expect it to trade sharply lower.

CASH: We're running into a bit of a seasonal lull this week. With the Fourth of July holiday creating a four-day weekend for most traders, the strategy was to get everything pressing taken care of the week prior. Now the underwriters need to take a step back and see what they can build a case for later in July.

JL: It seems like it would be hard to build a case for anything coming public right now. We just survived one of the worst Junes in recent history and the indexes are already down sharply for July. I can't imagine anyone is too excited about buying anything.

CASH: That's true... and yet bleak times often kick up the sharpest rallies. The biggest rallies actually come in bear markets, as I'm sure you know. Plus you probably remember the stellar performance of some of our IPO picks in April after we bounced off the Bear Stearns news.

JL: How could I forget? (You certainly wouldn't let me forget). So are you expecting another rally like we saw in April?

CASH: I think this next rally will be a smaller version of the last one. But we're not quite there yet. It's more a concept for us to keep on tap for another week or two. In the meantime, I still have some great short ideas that we can make money on.

JL: Great! So anything liquid enough that you can share it with a broad audience?

CASH: Yep, I've got one that works for Taipan Daily readers, but we need a different kind of confidentiality on this one. If I tell you about this short idea, you have to promise not to let it get back to Mrs. Cash.

JL: Uh-oh, I'm not sure I want to get in the middle of this one. Fending off questions from Wall Street brokers is one thing. But I certainly don't want to have to avoid the Lady Cash.

CASH: Ha ha. Well I'm only kidding (mostly), but shorting a girl's best friend could get me in hot water, as you can imagine.

JL: Hmmm? A girl's best friend, eh? Are we going to be trading diamonds somehow?

CASH: Pretty much. The stock I have in mind is Blue Nile Inc. (NILE:NASDAQ). These guys are the largest online retailers of diamond jewelry, and a great example of how a hot IPO can get ahead of itself. The actual IPO was priced at $20.50, and within a few short years the stock had traded over $100 for a 418% gain at its highest point. These kinds of gains are great fun on the way up, but they almost never end on a good note.

JL: So I guess that's why your flexible approach is key. Buy 'em on the way up, then short 'em on the way down...

CASH: Exactly. So the story with Blue Nile is that it experienced tremendous revenue growth, quarter after quarter, as consumers became more comfortable making big purchases online. It certainly helped that easy credit made it possible to splurge during the craziness of the housing bubble.

JL: And what better way to say "I love you" than to take out a home equity loan and buy a shiny rock!

CASH: That was the mentality. NILE revenues were getting a big boost from easy money in consumers' pockets. For a long time, when I would voice concern as to the multiple of the stock, people would brush me off, saying that the company was growing fast enough to justify such a high price. They added that if we ever did hit rough economic times, the diamond business wouldn't be hurt because rich people would still buy jewelry.

JL: So does Blue Nile cater to the wealthy and ultra-affluent?

CASH: No, it's actually quite the opposite. Sure, there are a few big pieces that get sold here and there, but the bread and butter for NILE is engagement rings less than $5,000. So we're not talking about financiers or big oil tycoons here. We're talking about college grads and young professionals ready to tie the knot.

JL: And that's part of the demographic that's feeling the heat from inflation, unemployment and an overall slowing global economy. Have you seen any of this actually hitting the revenue numbers for the company?

CASH: The revenue slowdown is actually just getting started. After growing revenues by 25-30% quarter after quarter, the March report came in at only 4% growth. The fact that NILE still saw some growth is encouraging to many, but there was a single large purchase that skewed the numbers. If this one piece of mega bling hadn't been sold, NILE would have actually seen sales decline, quarter over quarter.

JL: Not so good for a growth stock. But I notice that the share price of NILE is already down quite a bit from its high. Aren't you worried that the worst has already been priced into the stock?

CASH: Nope. This one should still have further to go. See people don't give up on a good idea easily. The stock still holds a multiple of 40 times this year's earnings. I don't know about you, but it's tough for me to pay for 40 times anything. This shows that people are still very optimistic that earnings will continue to grow. The realization has yet to sink in that this is yesterday's story. Honeymoon over!

JL: So where would you expect to get involved? What kind of risk control on a potential position?

CASH: The stock is breaking 40 as we speak. It's a great spot to look for potential entry between 38 and 40. A 20% stop is reasonable, so 48 is where a trader might start getting concerned. We'll get more volatility when the company releases earnings the second week in August, but I expect the movement to be mostly lower.

JL: Sounds good. We'll put that on the "growing and profitable trading" list. Speaking of the list of names you've mentioned here, I noticed that Verso Paper (VRS:NYSE) is down to half of its IPO value. It's dropped about 30% in just the last week... another nail you hit right on the head. Was there some news out for that one?

CASH: Nope. It's just trading the way busted IPOs trade. See, when there's no demand for a stock and the underwriters quit supporting it, there's nowhere to go but down. That's why the IPO confidential service has such value. We can separate the wheat from the chaff and make money coming and going.

JL: You're a twisted man.

CASH: A twisted man who makes twisted profits!

JL: No argument there. Well, I guess we'll see you over at IPO confidential. Looking forward to the more exclusive ideas there.

CASH: Talk to you soon.