Think the end is near? The stock market has been on a phenomenal eight-year run. But if you're convinced the good times can't possibly continue, you should be considering how to profit from the market's demise, or more conservatively, to protect your gains. One answer: Pull your money out of the market. Another potentially savvier alternative: Sell short.
Shorting is the flip side of buying stocks. Shorts sell borrowed stock, hoping to buy it back later at a lower price. The technique is frequently used by professional investors who play both sides of the market, betting that some investments will rise while others fall. But individual investors, even cautious ones, can use shorting strategies as well. "Short-selling is a perfect way to diversify and lower your market risk," says Michael Murphy, editor of the Overpriced Stock Service newsletter.
Anyone can short stocks to speculate on falling prices. But less venturesome investors can use shorting to hedge a portfolio's long-term capital gains against a broad market decline. The technique can also protect profits in a stock that has gone up sharply in value.
LOUSY RECORDS. The mechanics of short-selling are not difficult. But they carry risks that "long" investments don't have. When you buy a stock, you can only lose your investment. When you short, your risks multiply. Indeed, short funds, not surprisingly, have had lousy records in bull markets such as the current one. The Prudent Bear Fund, which maintains a constant short position against the market, is down 9.4% this year through Mar. 8. But it was among the top performing funds in the third quarter of 1998, posting a 22% return as the Standard & Poor's 500-stock index fell 10.7%.
In shorting, you borrow shares from a broker, sell them, and put the proceeds in a margin account (table). Federal regulations require short-sellers to put up additional equity to protect brokers against potential losses if the short sale goes bust. For most stocks, you have to put up 50% of the initial value of the short sale. But brokers charge different amounts, called a "maintenance requirement," for many stocks. The rate depends on such factors as the volatility of the shares and how easily shares can be borrowed. Charles Schwab requires a 70% margin for certain Internet stocks, and Fidelity Investments recently demanded 80% for shorting Yahoo! vs. just 30% for IBM.
The maintenance requirement can get short-sellers into serious trouble. If the price moves up after you have borrowed and sold a stock, brokers require you to put up more equity to cover the maintenance amount. If you don't watch yourself, you'll end up forking over more cash than the value of the stock you sold. Or if you don't have the cash on hand, the broker can sell other securities in your account to pay the bill. The risks are particularly high with volatile Internet stocks that can double in price in a day. Professional short-sellers recommend cutting your losses and buying back the stock if the share price rises anywhere from 15% to 30%.
Investors also can get burned if a stock being shorted rises, and the broker demands the return of the borrowed shares. That forces the short-seller to buy back the stock at a higher price.
Pros warn that speculative short-selling, in which an investor simply sells a stock short hoping the price will fall, is one of the riskiest strategies going. "When you're fighting a [market] mania, it's not something a part-time investor should engage in," says William Fleckenstein, president of Fleckenstein Capital, a short firm in Seattle, Wash.
But some specialists say a small portfolio of short positions can be used to hedge against losses in a large long portfolio. If you have $150,000 in long positions, say, you could simultaneously build a $20,000 portfolio of shorts. If the market goes down, chances are you'll make money on your shorts, offsetting some losses in your long portfolio. If the market goes up, you'll lose money in your shorts, but still profit on your longs. Edmund Kellogg, manager of the Boston Partners Market Neutral Fund, uses a variation of this long-short strategy and says it works best when long positions are hedged with a large basket of shorts. Kellogg is long on "value" stocks such as retailer Lowes, and short high-priced stocks losing momentum in a range of industries, including restaurants and technology. Among his shorts is rubber glove maker Safeskin. His fund is down 4.2% this year through Mar. 5.
You can also hedge a long portfolio through Standard & Poor's Depositary Receipts, unit trusts listed on the American Stock Exchange that track key market sectors and indexes. To create a hedge on a $100,000 long portfolio invested in an S&P 500 index fund, for example, you could short $20,000 worth of SPY, the SPDR that tracks the S&P 500. One advantage of SPDRs: They can be shorted on a downtick, unlike stocks.
Some investors might want to consider a short-selling strategy that can protect gains in an individual stock. Called "shorting against the box," it locks in profits on a stock you own after it has made a large gain. To do this, you short as many shares as you own long. If the price goes up, you remain even since you make as much money on the long as you lose on the short position. One downside: The Internal Revenue Service considers any proceeds from shorting against the box a short-term capital gain, even if you've held the long position for years.
THINNER RANKS. Instead of shorting a stock you own, you might want to short a similar one. This avoids the tax consequences of shorting against the box. Prudent Bear manager David Tice suggests if you're long America Online but worry Net stocks are headed for a fall, you could short Yahoo! as a hedge.
Figuring out which stocks to short is not easy. Pros tend to specialize in corporate fraud and companies with major financial problems. But in recent years this strategy has been hard to make money on. Shorts have also gotten killed making bets against highly overpriced Net stocks. The ranks of professional, full-time short-sellers have dwindled to 8 from 20 eight years ago, says Harry Strunk at Morgan Keegan, a Palm Beach, Fla., consultant that tracks money managers. The eight are mostly short hedge funds. They ended last year managing just $400 million, down from more than $30 billion when short-selling was popular in the early 1990s, Strunk says.
One excellent source of information on identifying stocks for shorting is The Art of Short Selling by Kathryn F. Staley (John Wiley & Sons, $49.95). The Internet is also a repository of information for shorts. One good place to start is Tice's Web site, www.prudentbear.com, which has links to other sites.
An alternative to shorting stocks yourself is to let a pro do it. This reduces your risks, since mutual funds maintain diversified portfolios. Numerous funds that short stocks aim to achieve different investment goals. Some, such as Prudent Bear, maintain heavy short positions in anticipation of a sustained bear market. Others, known as long-short funds, attempt to reduce their portfolio's exposure to market downturns while earning a better return than cash. They include Kellogg's Boston Partners Market Neutral Fund and Montgomery Global Long-Short Fund (box).
Considering Prudent Bear's negative 34% return last year, you need a strong conviction that the market is headed south to bet big on such a fund. But for nervous investors seeking to protect a long portfolio, shorting a few stocks or taking a stake in a short fund could soften the blow when the apocalypse finally arrives.