Preparing for a Pullback to Reality

• ByTim Melvin, RealMoney.com Contributor
• On 1:00 pm EDT, Thursday September 3, 2009

I am hopeful that Monday's selloff was the start of a good pullback. The consensus seems to be 10%, so I suspect it will be deeper than that.

I am not hopeful because I am a perma-bear or have a large short position. My only shorts right now are still the casual dining stocks I have been trading from the short side all year. I am hopeful because I want to see stock prices reflect reality.

The economy is still in bad shape, and there are still serious problems in the nation's banking system. The fact that banks have delayed recognizing losses does not mean they don't exist, and I believe we have a lot more failures ahead of us this year. Consumers are not shopping, and we are still losing jobs at a steady clip. As I said a few weeks ago, I believe the market needs to go under 750 on the S&P 500 for it to be undervalued.

I could be wrong, of course. It has happened before. Although my bearish stance since late 2007 has been right, I was suspicious of the March bottom and did not make nearly as much as I could have in the rally. Fortunately, I have tools to allow me to back into the market, so I do not have to be exact in my predictions. If we should fulfill the consensus, I can still make money using the back-in approach.

I will achieve this by selling puts on stocks I like when the market declines. If stock prices drop 10%, I will begin selling puts a strike or two down from those levels. If the market reverses and goes up, I pocket the premium. If the declines continue, I am buying stocks I like at prices that will be near the eventual bottom. The key to this strategy is that I have to like the stock at the strike price and want to own it. I put up 100% margin on my position to maintain a margin of safety in the trade.

I ran my screens yesterday afternoon and culled out only those stocks that are marginable. I looked first at those stocks that fit the Schloss screen but added those that are slightly above book value that may decline below that price. There were some interesting names that I would certainly be willing to own lower.

Superior Industries makes the cut as a cheap stock with a strong balance sheet and insider ownership. The company probably could not be in a worse business right now. Superior sells aluminum wheels to original equipment manufacturers of automobiles and light trucks. There may be a slight ramp up from a small inventory rebuild after the Cash-for-Clunkers program, but all in all, the auto business is horrible. Analysts estimate that revenue for the company could fall as more than 40% in 2009. It is certain to lose money this year.

The balance sheet is the key to this trade. It is a fortress. Superior has almost $160 million in cash and no debt on the books. The cash balance is half the current market capitalization. The stock trades at 90% of tangible book value right now and would be a steal if it dropped further. When prices drop, I will be looking to sell the $10 puts one and two months out to create a long position. Between the low strike price and premiums I can collect, I will own the shares at a price that is very attractive.

Titanium Metals is another stock that will pass the screen if it declines a bit further. Again, business is not exactly strong right now, as the titanium industry is very much dependent on the aerospace industry. Continued delays from the Boeing Dreamliner have negatively affected sales of Titanium Metals.

TIE has 15% of the global market, however, and at some point, demand will return. Again, the balance sheet is healthy with very little debt and a current ratio of better than 6 to 1. If the market drops, I will be looking for opportunities to sell puts that place the stock below tangible book value of $6.25. Astec Industries is another company that I would love to see fall back below tangible book value in a broad market decline. I have said on several occasions that I believe infrastructure will be the next bubble market, and this company should be right in the eye of the storm. The company makes road-building equipment and should be right in the sweet spot of government infrastructure spending in the future. The balance sheet is in good shape with no long-term debt. If the stock does pull back, I will be looking to sell puts and back into a position.

I like creating positions this way. It gives me a chance to buy stocks in a decline at lower prices. As a bonus, in broad market declines, volatility rises and options become more expensive as traders seek protection and make downside bets. As a seller who wants to own the stock, this higher premium collection is a potentially huge benefit. If we go down 10%, I keep the premium. If it goes further, I end up buying stock I want to own cheaply.

What if I am wrong on all counts and the stock market just keeps going higher? Then I will miss the trade and be happy about it. A rally from here would takes us to levels I consider dangerously overpriced, and I do not choose to play.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider SUP to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Buzz up!