Investors need to be on guard against "the sideways churn." This happens when a market that had been steadily rising is now see-sawing back and forth. Such a shift is often a sign that buyers are slowly pulling back and sellers are starting to take root. The sideways churn often presages the next move: a market downturn, where the sellers get even bolder and buyers lose interest.
With that in mind, it's time to focus on five companies that could see sharp pullbacks in the months ahead.
1. Sprint Nextel (NYSE: S )
Shares of this wireless phone service provider have risen nearly 50% since early December as optimism spreads that faster phone networks will lead consumers to justify ever-higher phone bills. Indeed, Sprint has been able to push through recent price hikes as it rolls out 4G service in more markets. But investors seem to be forgetting a few important facts.
First, Sprint's network remains inferior to its rivals, especially Verizon (NYSE: VZ ) . That may explain why Verizon continues to steal market share : it added 907,000 net new subscribers in the first quarter, while AT&T Wireless (NYSE: T ) , Sprint and T-Mobile lost a collective 400,000 subscribers. The clients Sprint is able to attract generally bring higher credit risks, signing up for monthly prepaid plans, as they lack the credit for extended contracts. Sprint's second-tier status led to -2% operating margins in 2010, and the company may only barely move into positive operating margins this year. That's mighty tough for a company that needs to spend $3 billion a year on capital spending just to keep up.
High costs and weak margins explain why short sellers hold 90 million shares , the fourth-largest short position of any stock on the market. After that 50% gain in six months from $4 to $6, I wouldn't be surprised if shares drop 33% from recent levels (from $6 to $4).
2. AMR (NYSE: AMR )
While just about every major airline carrier has sought to improve its position through mergers and alliances, the parent company of American Airlines hasn't been able to find a partner. Potential partners know that AMR is saddled with aging, inefficient planes and high labor costs.
The carrier would likely muddle through 2011 with those problems if oil prices stay in check and consumer appetite for air travel keeps building. Then again, a fresh spike in oil prices, or a slowdown in air travel, would deliver an especially tough blow for AMR, which carries almost $5 billion in net long-term debt . AMR has lost money for three straight years (a cumulative $3 billion) and although it's on track to make money so far in 2011, a setback for the broader air travel industry would push the carrier into the red once again. Short sellers have been boosting their position against AMR every month, and the short position has now reached 60 million shares.
How much might shares fall? Well, the last time airlines hit a rough patch in 2008, shares fell below $3 -- less than half the current price. It would take a full-blown economic slowdown to re-visit those levels, but AMR looks like the most vulnerable airline stock in such a scenario.
3. Netflix (Nasdaq: NFLX )
Short sellers are afraid to touch this stock. Every time they do, the stock rises to new highs and they have to cover their positions, pushing the stock yet higher. After rising more than 1,000% in less than three years, the next move may be down if persistent concerns out of the Apple (Nasdaq: AAPL ) camp are to be believed. [See: " How Apple's Big Secret Could Spoil Netflix's Amazing Run "]
Netflix now trades for roughly 40 times projected 2012 profits. Yikes! Is that a reason to short the stock? Not according to analysts at Needham. "Our underperform rating is solely predicated on the assumption that competitors will enter the streaming content subscription market." Amazon.com (Nasdaq: AMZN ) is already gearing up its video streaming service (ahead of Apple's possible move noted above), and others such as Dish Networks (Nasdaq: DISH ) and even mighty Google (Nasdaq: GOOG ) may follow suit.
A high price-to-earnings ( P/E ) multiple and rising competition has often been a recipe for disaster. Short sellers have been wrong so far, but their time may soon be at hand. If shares traded down to 30 times projected 2012 profits, shares would be looking at a 25% drop.
4. LinkedIn (Nasdaq: LNKD )
Investors are buzzing about this hot IPO , but it's not the kind of buzz you usually want. The buzz is all about the company's $9 billion market value , which appears very disconnected from the company's financial performance. Even in the best of scenarios of very high growth for the next few years, many find it hard to come up with a target price much higher than $60 or $70, well below the current $96 share price. Some think shares are worth closer to $30 or $40.
So why is the stock trading so far above its apparent fair value ? Supply and demand. There are relatively few shares available and no shortage of investors that want to get a piece of any social networking business model . But therein lies the rub. These investors are chasing the relatively few shares in hopes of seeing their investment get caught up in a mania. But what happens when shares start to cool off to $85 or $75? Those same investors will start to understand that they're holding something more mundane: an Internet-based business model that is unlikely to become the next tech titan. And if these currently enthusiastic investors start lose heart and begin selling, then shares could fall a lot faster than many realize. That's the downside of a stock with a limited trading float .
5. Rite-Aid (NYSE: RAD )
The fast-changing health care environment has many short-sellers betting against this drugstore chain. This is because Rite-Aid carries lots of debt, generates weak margins and would take a crippling blow if reimbursement rates for key drugs start to drop -- a real possibility if Washington goes through with entitlement reform. About 63 million shares are held short, accounting for a hefty 10% of the float.
The last time Rite-Aid was profitable was 2007. That's an unsustainable trend for a firm that carries more than $6 billion in long-term debt. Worst case scenario: this stock may eventually head to zero if a meaningful drop in drug sales leads to lower traffic at the stores.
Action to Take --> These companies could see their shares drop by a considerable amount if economic and company-specific business trends don't improve. They've managed to hang in there while the market was in rally mode, but a downbeat market could be especially tough for them. If you hold any of these stocks, you should seriously consider selling. And if you're feeling especially aggressive, you may want to consider shorting some of these names.
-- David Sterman
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.
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