Monday, May 14, 2007

The Short Sell Made Simple (Business Week)

By Lewis Braham

It's not only the bulls who cheer new highs on the Dow Jones industrial average and the Standard & Poor's 500-stock index. Lofty stock prices also make the bears more ferocious.

The reason: They sell stocks short. That is, they borrow them, sell them, and hope to profit by replacing the borrowed shares at lower prices. The lower prices go, the more money they make, and the higher the starting point, the more profit they see below.

What's the case for a market swoon? For starters, bears point out that the bull market is long in the tooth. "The typical bull market lasts 3 1/2 years, and then you get a 1 1/2-year bear market," says John Hussman, portfolio manager of the Hussman Strategic Growth Fund (HSGFX ), one of relatively few mutual funds that hedge against declines. "This market's been in rally mode now since October, 2002."

There are other arguments: There's too much debt in the system; the weak U.S. dollar will prompt foreigners to dump U.S. stocks and bonds; and the private equity funds that have been sopping up stocks will soon lose their sources of capital.

Should you feel bearish, it's getting easier to act. A growing number of mutual funds and exchange-traded funds are designed to short the broad market or narrow slices of it. Having launched some 29 short-selling ETFs in the past 10 months, ProShares Advisors has already gathered $3.9 billion. Some are even "ultra" funds, which are designed to deliver twice the return of a regular short fund.

No doubt part of the growing popularity for these funds is that they're less risky than outright short-selling. The most you can lose is the money you put in. With conventional short sales, the cost of getting it wrong can be far greater. Buy a $20 stock, and the worst case is the company goes bust and you lose $20. The most you can make shorting a $20 stock is $20. If you're wrong and the $20 stock you sold short goes to $50, you've lost $30. The higher it goes, the more you lose.

But with today's high prices, and the sharp tools investors have at their disposal, why not short? Because on the Street, short-selling is taboo. Strategists and analysts at the big investment banks almost never speak of it because advising investors to short is effectively the same as telling them not to buy stocks, and that's bad for their business. Institutional investors and mutual fund companies are mum, too, because they would only be talking down the value of their holdings. (Hedge fund barons do sell short, but they don't talk about their strategies in public.)

Even Proshares Advisors doesn't actively market its short funds to mom-and-pop investors, says Chief Executive Michael Sapir. Instead, the firm targets financial advisers and small-to-midsize pension funds.

Advisers who serve individuals see the advantages of the short funds. Anthony Welch, a financial planner and partner at Sarasota Capital Strategies in Osprey, Fla., uses ProShares' short ETFs to introduce some downside protection to portfolios that would otherwise have none. "Most of our clients have a mandate that we don't actually short because of the unlimited downside risk," he says. "These ETFs have limited risk." Another plus for the short funds: They're permissible in IRAs, but outright short-selling is not.

Those like Welch who use the short funds usually make small opportunistic plays rather than big bets on a crash in stock prices. For instance, small-cap stocks have beaten the S&P 500 seven years running, leaving many to argue that small-cap stocks are overpriced. Even veteran small-stock investor Charles Royce recently declared in a shareholder letter that a "historically typical correction of 15% or better is in the near future." When someone like Royce, whose firm Royce & Associates runs $26 billion in small-cap investments, says watch out, maybe you should.

Here's a strategy. Start by buying the ProShares Short SmallCap600 (SBB ) ETF. Then pair that with an investment on the long side, say, a large-cap growth fund or ETF, one of the worst-performing, and thus cheaper, sectors. A possible choice is Vanguard PRIMECAP Core Fund (VPCCX ), run by top-performing growth-stock managers. The bet pays off if big blue chips outperform small caps.

You can also target industries or sectors you think are overvalued. One industry many strategists believe to be overvalued is commercial real estate, and the way to play that is through real estate investment trusts (REITs). "REITs are at the top of my list of overvalued assets," says Jason Hsu, director of research and investment management at Research Affiliates, a Pasadena (Calif.) money management firm with $22 billion in assets. The knock: REITs are bought for income, but prices are so high that yields are at historic lows, nearly one percentage point below Treasury bills. Banking is another overvalued sector, says Hsu. The subprime mortgage mess makes that sector a good short-sale candidate.

You could pair these short positions with ETFs or mutual funds that invest in health care or consumer staples. These sectors have done poorly in recent years but tend to do well in bear markets, since people always need medicine and food. "A lot of the stocks we own are in the consumer and health-care sectors," says Hussman. "The consumer is the most stable part of the economy."

The trickiest part of putting your money into a bearish bet is the timing. You can be right that a market or sector is overvalued but wrong on the timing. That's essentially what economist John Maynard Keynes meant when he said, "The market can stay irrational longer than you can stay solvent."

That's less of a problem with short funds, since losses are limited. Still, if you're getting aggressive in your wager against the market, you have to figure out what the bear-market triggers might be. Two areas to watch closely are the private equity market and interest rates. The billions private equity funds have been pouring into stocks to buy out public companies have been propelling the market higher. These deals are financed with low-interest loans, but should interest rates rise, private equity's cheap money would disappear.

Ultimately, the market's downfall may be its old nemesis—inflation. If consumer prices rise yet the economy continues to cool, the Fed's hands will be tied. It will not be able to lower rates to spark growth for fear of causing further inflation. In fact, in such a scenario, rates on private equity debt will certainly go up. What's more, since the economy is overleveraged and indebted at every level, from the federal government to individual consumers, higher rates would be bad for every borrower. Inflation could be the perfect trigger for investors looking to make a killing on the short side.

1 comment:

Anonymous said...

Los Angeles private equity and hedge fund borrowing are the main things propping up the stock market these days. That won't last forever, but for now it's hiding the real economic damage that is being done.The tax issue is valid, and something most people can understand, but the real tragedy of the current situation is much more complex.