Short Selling Stocks

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Short Selling Stocks: Is It Time?

By Dr. Steve Sjuggerud, Advisory Panelist, Investment U
Friday, April 1, 2005: Issue #424

“Short selling stocks is painful, difficult, and not particularly lucrative…” the Wall Street Journal said yesterday. So why would anyone even consider doing it?

Even worse, “it’s become harder,” the Journal says, thanks to changes in Wall Street practices and tax laws. For example, when it comes to taxes, profits from short selling stocks are NOT eligible for favorable long-term capital gains tax rates. What a dirty trick.

So what we can extract from this is that shorting selling stocks is difficult, hard to make money on, and onerously taxed. No wonder not many people are doing it.

But a-ha! Not many people are doing it… Hmm… That gets me interested…

I contacted a short selling aficionado I know who has made an extraordinary amount of money on his short stock picks so far this year. (I can’t reveal his name, as short sellers don’t like the companies they’re shorting to know who they are.)

He currently thinks the market is actually set for one last gasp higher right now, but also thinks it’ll be an ideal time to begin short selling stocks very soon.

So let’s now take a look at short selling stocks, what it means, and how to make money from it…

A Quick Guide to Short Selling Stocks and How to Profit from a Fall in the Market

“Selling short” is how you profit from a fall in the market, or in a stock. In a typical stock trade, you want to buy low and sell high, of course. When it comes to short selling stocks, it’s the same thing, done in the opposite order you actually sell high first, and hope to buy low later, to close out your trade.

Some of the most successful folks in the history of Wall Street have been short sellers… guys like Jesse Livermore and Daniel Drew.

So who’s a famous stock short selling guru today? You probably can’t name one. And it makes sense: Short sellers make money when stocks fall, and stocks have basically gone up since 1982 (with the exception of a brutal 2000-2002). So we’re looking at over two decades of swimming against the tide.

The 1982-2000 bull market in stocks was the longest, greatest bull market in the history of stocks. Even the best short sellers were clobbered. Today’s best-known short selling expert, Jim Chanos, said in the Wall Street Journal yesterday: “You lose money pretty much all the time, and when you make it, you make it in outsized amounts.”

But stocks can’t go up forever. And whether you want to believe it or not, it would naturally follow that after the longest bull market of all time, we could well enter the longest bear market of all time. And who can make money in that environment? Someone adept at short selling stocks… that’s who.

When to Start Short Selling Stocks: The Strategy

The pro I talked to today has a relatively simple strategy for short selling stocks. He does the same thing I do when I’m looking for something to buy… only the opposite.

When I’m looking to invest, I want to buy an asset that is…

An extraordinary value
Is hated
Has just begun its uptrend

To do the opposite – to sell short – the pro I talked to is looking for a stock that is

Exceptionally overvalued
Is loved
Has just begun its downtrend

When I pressed him for a tip, the pro actually said the entire market meets these criteria right now. Stocks are overpriced, and in a downtrend. He’s expecting a quick rally, to get people to “love” stocks again… And then it sounds like he’ll go aggressive with short selling his stocks in a few weeks time.

How to Profit from the Downside In a Diversified Way (Even in Your IRA!)

Now, picking individual stocks for short selling is tricky business. One thing you might consider doing instead is to sell short in a diversified way…

Two mutual fund groups offer “inverse” funds… and even “double-inverse” funds… that promise twice the inverse return of an index like the Nasdaq.

And then there are funds like the Prudent Bear Fund, which is a managed bear fund that seems to do extremely well when the market is falling. This gives you plenty of options for profiting from a fall in the market in a diversified way – and these mutual funds can even be held in your IRA!

If you’re looking for books and resources on short selling, the shelves are pretty thin. Your best bet is probably The Art of Short Selling, by Kathryn Staley. There’s not much else worth reading. (William O’Neil has a new book out about selling short, but I thumbed through it in the bookstore and put it back on the shelf. It only had a few pages of text, followed by a lot of charts in the back as filler. Buy the Staley book instead!)

A Two-Decade Bull Market Could Be Ending

Stocks are expensive right now, and the downtrend seems to be getting underway once again. We’re coming off a full two-decade bull market, which has knocked out most short sellers. Now may be the time to get into it, as we may be on the brink of a major bear market… and folks who do their homework can make some money selling short.

There is very little competition on the short side (as the long bull market forced traders trying to specialize in shorting to throw in the towel)… so good homework on the short side could potentially be really profitable in the coming years. It’s definitely worth learning more about right now…

Good investing,

Steve

Today’s Investment U Cribsheet

Before you start shorting, you’ve got to educate yourself… Buy The Art of Short Selling by Kathryn Staley, and visit these websites to learn about profiting from the downside with some degree of safety with “inverse” funds: http://www.prudentbear.com, http://www.rydexfunds.com, or http://www.profunds.com.