Anarchists and bear markets

The date was September 6, 1901. US President William McKinley was standing in line at the Buffalo Pan-American Exposition - the equivalent of today's Disney World and a state fair all mixed into one.

It was a gorgeous sight. There were over 500 sculptures by well-known artists like Roth and Vanderbilt. Scattered over the grounds were 200 outdoor flower beds filled with 20,00 fresh roses, 3,000 dahlias, and 50,000 tulips. Everywhere you looked, there were beautiful fountains adorned with golden trim and intricate figurines. The immaculate parks and walkways were peppered with people buying fresh popcorn, fudge and lemonade.

Anyone who was anyone came to upstate New York to walk these grounds, including the President. But while he was greeting people in line, Leon Czolgosz - a well known anarchist - shot the 25th President of the United States twice at point blank range, once in the chest and once in the abdomen. He had hidden his 32-caliber pistol beneath a handkerchief he was carrying. No one had noticed it.

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President McKinley died a week later - while reportedly reciting the hymn "Nearer my God to Thee, Nearer to Thee."

It was a sad day for the United States. McKinley was known as a pro-business president - always looking out for American companies and its workers. Besides issuing a high tariff on imported goods (50% higher than anything that existed before) to encourage US trade, McKinley had the backing of some of the most influential businessmen in the world - including J.P.Morgan and John D.Rockefeller. So when he was shot on Sept. 6, 1901, the Wall Street markets reflected the uncertain atmosphere.

The Dow Jones Industrial Average plummeted nearly 9% - from 72.72 to 66.22 in the days following the assassination. A similar move today would push the Dow from 10,200 to 9,282.

The New York Times tried to downplay the event. Its headline on Sept. 7 read: "Confidence in Financial Circles...No Occasion For Excitement."

But the major financial gurus weren't so sure everything would be alright.

J.P.Morgan was quoted as saying, 'This is, indeed, very, very sad news. It is impossible to say anything as to the effect upon the market and upon conditions in general.' And Charles Schwab, president of US Steele and eventually of his own financial company, said, 'Should the president die, it would certainly have a most depressing effect upon business and industry."

The US market's prospects looked ugly in Sept. 1901. That is...it looked ugly for all the perennial bulls who did nothing more than buy, buy, buy and hope the market always rose. Of course, we know the market doesn't always rise. And in 1901, Bernard Baruch, one of the day's greatest traders, was happy to see the market plummet.

Baruch knew you could make money on the short side of the market just as easily as you could when everything rose. To prove it, he shorted one of the largest copper miners in the world - Amalgamated Copper - right after word of President McKinley's assassination attempt.

It proved to be a finically wise decision. Copper supply far exceeded demand after the assassination in 1901. As a result, shares of powerhouse Amalgamated Copper fell from $130 to $60 a share, and Baruch netted $700,000 from the trade - the equivalent of $15.5 million today.

Not too shabby for a 31 year-old who started his career on Wall Street making $5 a week! And his success only continued from there...

By the time Baruch was 32, he retired from Wall Street with $3.2 million in his pockets. He credited his success to two things - being able to change his investment views as the market changed, and detaching from all human emotion when it comes to making money in the stock market.

Sounds easy to do. But how many of us simply add stocks to our portfolio no matter what the market is doing? Probably most. And how many of us hold onto a position way too long because of pride or ego? Again, probably most.

If you are serious about making money, you must be willing to trade with the prevailing trend of the market. And right now, that trend is bearish for US stocks. Despite a bullish 2003 and 2004, the Dow Jones Industrial Average is still 1,267 points below where it was in Sept. 2000. The NASDAQ is off its highs by more than 2,000 points. And the S&P 500 is down 235 points.

But the problem is, US stocks still aren't exactly cheap right now. The average stock on the S&P 500 trades for 20.2 times earnings and 2.81 times book. And if you look at the NASDAQ, the average P/E is still in negative territory. Not good for our bullish friends.

So I wondered...if Bernard Baruch was alive and trading today, what stocks would he likely short in this ugly market?

After snooping around on the NYSE home page, I discovered a list of the top 100 short positions - measured by monthly short interest compared to average daily trading volume. From there I separated out all the companies trading for a premium to the overall market in terms of price to sales and price to book value. I came up with a list of ten overvalued companies to place on your short list:

CryoLife, Inc. (CRYEnzo Biochem, Inc. (ENZF.N.B. Corp. (FNBPre-Paid Legal Services (PPDRogers Communications, Inc. (RGTelstra Corp. (TLSThe Town and Country Trust (TCTTriarc Companies, Inc. (TRY.BUniversal Technical Institute, Inc. (UTIWMS Industries Inc. (WMS)

Collectively, these ten stocks trade for about 140% more than the average stock on the S&P 500 in terms of price-to-sales and price-to-book value. Couple that with the high amount of short interest, and I'm willing to make you a gentleman's bet...

In the coming months the people who short these ten pathetic stocks will outperform the US market as a whole.

Only time will tell if I am right. But I know one thing. The traders who can adapt their strategies and trade with the market, not against it, will walk away far richer than those who buy no matter what the market does. Bernard Baruch proved it on the early 1900s - retiring at the age of 32.

You have a chance to do it now. Can you adapt?

Unsure how to "sell short" now the bear market's back?

James Boric is a leading small-cap analyst in the United States. The publisher of Penny Stock Fortunes and Penny Sleuth, he is also a regular contributor to the free Daily Reckoning email where a version of this essay first appeared.