April 28, 2015
Why Now Is A Good Time
To Short Stocks
By David Sterman
Would you subscribe to an investment strategy that only works a couple of times every decade?
That's the question that short sellers need to ask themselves. These contrarian investors, who borrow shares with an intention to buy them back later at a cheaper price, rarely have the wind at their backs. (For a more extensive description of short selling, please read this.)
The first few years after the dot-com boom ended, short sellers had a nice run. They racked up great gains in 2008 as well. That's it... Two ideal windows of opportunity in 15 years.
And we're not cherry-picking the data. In the 1980s, the S&P 500 lost value just once (1981). And in the 1990s, the index also had just one down year (1990).
Short selling is so tough simply because, over the long haul, stock markets inexorably rise in value.
But that doesn't mean short selling has no role to play. Savvy investors will tell you that by adding selective short positions to an otherwise long-oriented portfolio, you can boost your risk-adjusted returns.
The key is to take a "long/short" approach when the stock market isn't surging quickly higher. In fact, when a stock market is in a period of tepid gains, this dual-pronged approach can really shine.
Right now could be the perfect time for this approach. While the headlines say that we're still in the midst of a torrid bull market, the S&P 500 has gone almost nowhere since Thanksgiving.
 The sideways market has brought the phrase "130/30" back into focus for some of the world's most sophisticated investors. That phrase refers to an investing approach that aims to have 130% of a portfolio with a long exposure and 30% short exposure. That may seem like a mathematical impossibility, so let us explain.
Let's say you invest $10,000 in a basket of stocks. You would then short $3,000 in stocks that you believe to be overvalued. Proceeds from those short sales are then used to purchase an additional $3,000 in stocks thought to be undervalued.
Last summer, Morningstar and Barron's joined forces to conduct a survey among the country's leading financial advisors. These advisors said that long/short funds, including those that use the 130/30 approach, are among the most appealing investment options out there these days.
Sure, these advisors are interested in building wealth for their clients. But they are equally concerned about not losing any money, especially now that we've seen the stock market enter its sixth year without a major correction.
Morningstar maintains a list of mutual funds by category and currently tracks more than 200 under the "long/short" heading. The average fund has racked up a 4.6% gain over the past year. But results vary greatly. Some funds are up by double-digits, while many others have generated only tiny gains or outright losses in that time.
Tepid performance is a real concern, especially when you consider that many of these mutual funds carry stated expense ratios in the 2%-to-3% range and also have a series of hidden "management fees" that sap returns.
Simply put, if you're going to pay for investing acumen, then it better be worth it.
That's the view of Dr. Thomas Carr. Nearly nine months ago, Tom launched StreetAuthority's Trader's Edge system. And in that time, he's proven the investing maxim that you shouldn't outright bet against the stock market. Instead, he uses a more risk-savvy approach that involves shorting, which has paid off handsomely.
In every issue, Tom presents three long investment ideas and three short ones. Don't overthink it, Tom suggests. Deploy an equal-weight position on all of his picks. (It's not the 130/30 approach that some investment advisers prefer, more like "100/100.")
Since Tom started writing Trader's Edge, the S&P 500 has risen 7.1%. In that time, Tom's long positions have gained 65%. His shorts have generated a 44% loss. Net those against each other and you'll get a 20.7% return. That's nearly triple the gains of the S&P 500 over the same period.
But that's not the point. Tom's long/short approach is "market neutral," which means he has systemically reduced market risk. Generating solid returns with lower risk is the goal for every investor, from the top hedge fund managers to the millennial investors that are just getting going.
Make no mistake, Tom's 65% gains from his long picks are extremely impressive. In fact, two weeks ago, one of Tom's long picks -- Builders FirstSource, Inc. (Nasdaq: BLDR) -- made a huge acquisition announcement, sending shares up 93% since he first recommended it.
Investors may be tempted to focus on his longs and ignore his shorts, but that would be unwise. One of these days, and nobody knows when, the stock market will hit one of its periodic air pockets. And when that happens, Tom's shorts are bound to outperform his longs.
We'll say it again... Don't over think it. Deploy Tom's long/short approach for the best combination of upside potential and downside protection. To learn more about the market neutral approach Tom uses in Trader's Edge and begin receiving his weekly trades sent to your inbox, go here.
Good investing,
David Sterman
StreetAuthority Daily
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