The bulls may be just beginning to run, according to Tom Taulli, co-author of The Streetsmart Guide to Short Selling. And if that's the case, this is not an opportune time for short selling, Taulli advises. He bases his optimism about the market on a view that, at a time when managements have done a lot of housecleaning, many stocks are below their true value and fundamentals such as interest rates should encourage spending.
These were among the points Taulli made in an investing chat presented May 22 by BusinessWeek Online on America Online, in responding to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. A full transcript is available on AOL at keyword: BW Talk.
Q: What kind of trend do you discern in this stock market?
A: ...I think that we're in the early stages of a bull market. We've had a very difficult time for the past three years, but companies are now much more streamlined and investors appear to be reallocating their money into equities because the alternatives provide returns that are just too low. My portfolio has done better since I've started investing in the past seven months. Where I've focused my portfolio has been in the small-cap sector, which is starting to come alive and provide significant returns.
Q: I've heard that part of the recent market rally is from short sellers covering their positions. Do you think bears still have reason to worry?
A: I would be very concerned if I were a bear in this market. Keep in mind that short sellers face unlimited risk, whereas the highest return a short seller can make is if a company goes bankrupt is a 100%.
Historically, looking at short sellers, they do very badly during bull markets, so I would not be shorting. As to whether this market is driven by a short squeeze, I think that's a partial reason, but it's only a short-term reason. Ultimately, bear markets are about the fundamentals, and I think that fundamentals will start to get better and better over the next couple of years.
Q: Can you give some reasons why you've become more bullish?
A: One is that valuations have come down too low and don't reflect the actual value of the underlying assets of Corporate America. I've talked to a few companies recently that are doing very well but are considering going private because their stock prices are well below the value of the companies.
The past three years have been very grueling for CEOs. Many of them have been spoiled by years of growth, but now they've been tested by difficulties and have been forced to learn and adapt. This will be reflected in better companies down the road. I consider that a very positive sign for the market.
There's a significant amount of fiscal stimulus in the economy in terms of both spending and tax reduction. Interest rates are at historical lows and this makes it easier for consumers to borrow and spend money. I think the consumer isn't out of the game and will continue to spend. The markets tend to anticipate trends, not be behind them. The markets have been showing strength lately, and this isn't a temporary issue -- it's the beginning of a bull market.
Q: A very basic question: How do I sell short and why?
A: I'll go through the "how to" first. Let's say that you spot the next Enron. The stock price is going to zero. Currently the price is $100 per share. The process is the reverse of buying a stock. With a short sell, you will sell the stock first, then buy it back later. But you have to borrow the shares from another investor in order to sell the stock in a short sell.
So you borrow shares of Enron from a brokerage firm, sell it today for $100. If it goes to $1 a share, you buy it back at $1 and make a $99 profit. You then return those shares back to the firm you borrowed from. That's known as covering your short positions. For a big stock like Cisco (CSCO) or IBM (IBM), it's very easy to borrow stock to short. However, there may be some companies -- like a distressed airline -- where it may be difficult to borrow stocks to short.
The basic reason for shorting a stock is you believe the price will fall. You have to pay interest on the stock you borrow, though, so the longer you hold onto the stock, the higher your cost. And, if the stock you short isn't really the next Enron, but the next Microsoft (MSFT) and keeps going up and up, you'll have to put more margin against that position.
If you can't afford to do that, the firm will close out your position and buy back the stock. This is known as a short squeeze, which can temporarily spike a stock's price. Short selling is fairly sophisticated, and if you want to engage in the practice, it's usually a good idea to start slow and learn the mechanics.
Q: Have any faves to short right now?
A: I think another sign that we're in a bull market is that I have yet to find good short candidates. Currently, I'm not short on any stocks, but I always look for those opportunities. I'm looking for short-term opportunities, say three to six months. Holding onto a stock to short incurs interest.
One position I'm looking into is that Countrywide Credit (CCR) executives are selling a lot of stock. That's a danger sign that I look for when considering the short. But there may be a little bit more on the upside before the stock begins to fall. But that is on my radar screen right now.
Q: You talked about doing well lately in small-caps -- can you give us any specifics on sectors and stocks?
A: My main focus has always been on technology, and I think for any investor, it's a good idea to focus on a few sectors when you're picking individual stocks. With small stocks you have an advantage of finding inefficiencies in the marketplace that you couldn't find with the mid- and large-size stocks.
I try to find creative ways to get an edge, and get some insight into a stock and where it could go. That means a lot of research. For an individual investor, it probably makes more sense to use a mutual fund than to buy individual stocks.