The short circuit at Circuit City

• Sell short 2,200 shares of Circuit City Stores (CC, news, msgs) at the open.

• Sell short 3,100 shares of Blockbuster (BBI, news, msgs) at the open.

• Sell all shares in Vanguard Total Stock Market ETF (VTI, news, msgs) at the open.

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Circuit City and Blockbuster have been "swimming naked" for quite some time, and I believe these two low-rated stocks (each sporting one lowly star in our CAPS reader stock-rating system) are good short-sale candidates. Granted, much of their pain is reflected in their current share prices, but I think there's still plenty of room for them to fall.

Perhaps just a bit of background is in order.

As I sit to write this it's Friday morning, June 27, and those who follow the market closely don't need to be reminded that most stocks took a pounding Thursday. In fact, on my way into the office this morning I heard on my usual news/talk radio station that while June isn't quite over yet, it's been the worst June on record for the stock market since the Great Depression. I also caught wind of a news story reporting that consumer confidence has it a new 28-year low.

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As I've written before, it is during challenging, uncertain times like this that I think some of the best investments can be made. Great companies are marked down along with everything else and offered at sale prices. It is also during challenging economic times that not-so-great companies find themselves in ever deepening trouble.

As Warren Buffett put it, "You only find out who is swimming naked when the tide goes out."

Short circuit at Circuit City

Circuit City Stores (CC, news, msgs) shares got hammered last week as the company reported same-store sales were down 11%, noted a quarterly loss of $168.4 million (compared to a loss of $54.6 million in the year-ago quarter) and forecast a wider loss than analysts estimated going forward. It has also announced suspension of its dividend. Ouch!

But with consumer confidence at a 28-year low, performance like this from a retailer of big-ticket items like flat-screen televisions is somewhat expected, right? Maybe, but let's take a quick look at one of Circuit City's biggest rivals, Best Buy (BBY, news, msgs). In its most recent quarterly announcement, Best Buy reported a rise in overall sales, earnings and same-store sales. What's more, Best Buy increased its dividend in the past week.

Given this, I have a hard time believing that Circuit City's problems are predominantly market-driven -- and I think any continued softness in the economy is going to impact Circuit City far more negatively than the company's better-run competitors.

Some of you following Circuit City may at this point be thinking, "Yeah, but Circuit City's going to be bought out!"

Blockbuster deal?

Sure, there's an offer in excess of $1 billion from Blockbuster (BBI, news, msgs) on the table for Circuit City. Blockbuster's currently doing its due diligence -- but this would be a match made in purgatory.

Blockbuster has enough troubles of its own. It's already burdened with a lot of debt (represented by a long-term debt to equity ratio of 1.22), and it has been destroying shareholder value for years (its five-year return on assets is -16%, and its five-year return on investment is about -28%).

So you have a company that can't seem to get its own house in order offering to pay a huge premium to acquire another company that is in trouble. On the one hand, I can't blame Blockbuster for trying to diversify away from its struggling core business. But buying another troubled company isn't the answer -- especially for more than $1 billion when Circuit City's market cap sits in the neighborhood of $570 million.

Frankly, I don't think the merger's going to go through. It just doesn't make any sense.

There is a bit of risk here as there has been talk of other suitors and that an acquisition of Circuit City may make some sense as a pure asset play. But despite the rumors, I don't see that happening anytime soon and I believe that Circuit City's shares will continue to languish in the meantime. So I will short it, betting that shares will go down.

I'm short-selling Blockbuster here, too. Between lower cost competition like Netflix (NFLX, news, msgs) and the rise in video on demand, I think Blockbuster's business model is in serious jeopardy – especially if management's answer is to attempt to acquire another company that is equally troubled.

Also, consistent with my strategy of staying fully invested via ETFs and replacing these holdings over time with individual stock positions, I'm selling all shares in the Vanguard Total Stock Market Index (VTI, news, msgs).