Thu Dec 04 2014
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Why I’m Betting Against This Hedge Fund Guru

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One book that comes up over and over again when I talk to technical analysts is Edwin Lefevre’s “Reminiscences of a Stock Operator,” written back in 1923. This book tells the story of Jesse Livermore, one of the greatest traders of the early 1900s, and certainly one of the most colorful characters in Wall Street history.

The stock market back then was much different than today. Livermore actually learned to trade in “bucket shops” — backroom establishments where people would come together to “buy” and “sell” stocks and commodities. The problem with bucket shops, and the reason why they’re now illegal, is that these transactions were never actually executed on an exchange, and amounted to no more than gambling on whether their pick would go up or down.

In bucket shops, traders followed the price action on ticker tape controlled by the bucket shop operator, who would usually use this power to delay and manipulate the numbers to create losing trades for the customers in the shop — and winning trades for himself. While many traders lost to the bucket shop operators, Livermore was able to beat them, and quickly made enough money to move his operations to Wall Street.

But shady schemes weren’t confined to back rooms and bucket shops. Once on Wall Street, Livermore worked with and against “pools” of large investors who would buy certain stocks and then leak stories to the public to drive prices up even higher. Once the price had soared, the pool would sell their holdings all at once, collecting a large profit and leaving outside investors holding the bag as shares crumbled.

If that sounds at all criminal, it’s because it is. Today, the Securities and Exchange Commission (SEC) has made this scheme, known as a “pump and dump,” illegal.

But Livermore is well known for saying, “I learned early that there is nothing new in Wall Street.” So he probably wouldn’t be surprised to see that some hedge fund managers are still trying to influence the market today.

For example, it’s perfectly legal — and common — for hedge fund managers and major investors to buy or short a stock and then use their immense social clout to make their opinions the loudest in the room, which may encourage others to buy or sell.

That’s what’s happening with David Einhorn and U.S. Steel (NYSE: X). Einhorn is one of the most prominent investors around today. Through his firm, Greenlight Capital, Einhorn has been very vocal about his investment opinions.

You see, Einhorn has been publicly criticizing U.S. Steel for the past two years. And while we can’t be 100% sure — major investors aren’t legally required to report short positions to the SEC — many analysts believe he’s betting that U.S. Steel’s shares will fall.

According to Bloomberg, Einhorn first launched his negative critique of U.S. Steel on May 16, 2012, during a major conference where top fund managers unveil their best investing ideas. Einhorn put a spotlight on the company’s mediocre earnings, high pension costs and China’s slowing demand for iron ore.

U.S. Steel fell more than 20% in the year following Einhorn’s comments, but eventually began to pick back up. Since the May 2012 conference, shares are up nearly 60%.

So it wasn’t really a surprise when Einhorn released a statement questioning the company’s ability to generate profits in the future. But Einhorn isn’t trying to provide a public service — he’s most likely trying to help nudge the share price back down.

Following his statement that the company had reached peak earnings, shares fell more than 6.5%. But most analysts disagree with Einhorn.

I believe Einhorn’s comments are biased and don’t highlight the fact that U.S. Steel is undervalued and will likely see continued profits in the future. What Einhorn is ignoring is that the overall global demand for steel is rising.

Steel production has been increasing steadily since 1980. So even if imports rise, U.S. Steel and other U.S.-based steel producers are still operating in a growing market. Their output, and earnings, can increase even as imports rise.

Of course, the key to continued profits for U.S. Steel will be controlling costs, a factor the company has been focused on for the past few years.

You see, hedge fund managers “talk their book” all of the time. While Einhorn is a great investor, he’s been wrong in the past, and there’s some very convincing evidence that U.S. Steel has a bright future ahead.

Since I’m a believer in U.S. Steel’s long-term prospects, I wanted to utilize the best strategy to profit from any rally in the stock. Thanks to Einhorn’s negative comments, the stock’s volatility has been increasing — helping to set up a lucrative income trade my readers and I use in my newsletter, Income Trader.

While most investors will simply buy a stock and hope for it to rise, my put selling strategy has the potential to be much more profitable. This trade allows me to either generate an 8.9% profit in 71 days without ever owning shares of the stock, or it will allow me to buy shares at a nearly 25% discount to current prices.

Here’s the great thing about this strategy: In both scenarios we have the possibility of earning double-digit annualized returns. Even better, you can repeat it multiple times and scale it up as much as you want. And it can work in almost any market environment.

In fact, this strategy has worked out so well that out of my 52 closed trades, all have been winners. To learn exactly how you can make the same winning trades, click here.

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