Looking To Profit From the Market's Plunge

Thank god for shorts.

Virtually anyone who has employed a buy and hold, long only strategy this year has felt a world of pain. As I write, the S&P 500 is down 12% for the year, having staged its worst June performance since 1930. Many great businesses—Starbucks, Coke, etc—have seen their share prices fall dramatically. Other, not so stellar franchises—GM, Citigroup—have fared even worse and seemed destined for bankruptcy or break-ups.

To me, investing in this climate requires one of two features:

1. An extremely high pain threshold
2. Flexibility

Regarding the former, today’s climate is a long-term investors dream come true. Countless high quality blue chips—the best of the best—are trading at prices we haven’t seen in years—I detailed a few such companies in our May 13 2008 essay. Anyone who can buy now and simply ignore their portfolio for five years should do quite well.

However, doing this is not nearly as simple as it sounds. Few, if any, investors have the discipline required to watch an investment lose value for a year, let alone two. We are, after all, in a bear market, and corporate profits are diminishing. In these environments it doesn’t matter how fantastic a business is, share prices can still plummet. Not selling can be excruciating. And often times you end up bailing at the best possible moment to remain committed.

To me, option #2 is the far more attractive approach. Investing has always been an art form more than a science. Even Warren Buffett, who avoids new fads like the plague, has altered his investment strategy dramatically throughout his career—first by shifting from the undervalued “Graham” method to focusing on franchises with “economic value,” more recently by investing in currencies and international companies.

Flexibility is absolutely essential to making money in the market, which is why I’ve been advocating the use of shorts for the first time in years. To me, finding opportunities that are heading downward has become far easier than finding ones that will rise in value. And thanks to the creation of several new investment funds, shorting today is easier than ever before.

For those of you who are unfamiliar with the concept of short selling, or “shorting,” it typically goes as follows. Typically, when you invest in a company, you buy low and sell high. Short selling is the exact opposite: you sell high and buy low. That is, you borrow the shares from a brokerage firm, sell them on the market—thus pocketing cash. Once the stock falls in value, you buy the shares back on the market and give the shares back to the brokerage. You then pocket the difference between the two prices.

The process is more complicated that the traditional “going long” strategy in which you simply buy shares and wait for them to appreciate. Because of this, many investors are hesitant to engage in short selling. Also, for some reason there is a psychological component to investors’ unwillingness to go short—investors, particularly those who came of age during the bull market from 1982-2000, are biased to think stocks generally head upwards.

Fortunately, there are a number of short funds and short ETFs to get around this issue. With these funds you essentially go short, by going long. You see, these funds are inverse funds. That is, they return the inverse of another fund or ETF. A perfect example is the Short S&P 500 ProShares (SH).

SH returns the inverse of the S&P 500. So if the S&P 500 falls 5%, SH rises 5%. IF the S&P 500 falls 10%, SH rises 10%. And so on.

By buying SH, you’re following the typical “going long” strategy of buying low and selling high. However, overall, you’re profiting from the market declining. So you are, in a sense, going short by going long.

There are dozens of these sorts of funds. You can short individual sectors—tech, consumer discretionary—or various indexes—the S&P 500, Russell 2000, Nasdaq. There are even a number of UltraShort funds that return 2X the inverse of another index. A perfect example is the UltraShort Dow 30 ProShares (DXD).

DXD returns 2X the inverse of the Dow 30. So if the Dow 30 falls 5%, DXD returns 10%. If the Dow 30 falls 10%, DXD returns 20%. However, the same applies in reverse, if the Dow 30 rallies, you’ll suffer 2X the losses.

I’ve recommended two short funds to readers of my advisory service International Wealth Advisory this year. Thus far we’re up over 60% and 20%. And I expect we’ll be opening more of these positions if the market continues to plunge.

Investing is all about adapting to the market climate. There’s no reason you can’t make big money in a bear market. And thanks to short funds, doing this is easier than ever before.

Comments

[Leser]

Really well explained comment on shorting. Thanks. I don't think I'll do it now, because it seems one would have to watch the market relatively closely. However, it is a good review of shorting and introduction to some of the funds one might use to have managers help in doing it. So, with your explanation in mind now I'll watch the market to see "how I might do" if I were to invest at given points. I'd have to analize this for some time before I would trust myself to short stocks--even though I constantly read about equities and I've been investing actively since 1992. I appreciate the clarity of your article on what has been for me a seemingly illogical topic.

[sopocistudio]

Leser,

I understand your reluctance in using short and ultra short funds, because I was more than a bit hesitant to do so, as well, but after using SDS for just under a year, I'm only sorry my position wasn't larger.

Despite being overweight financials (by a factor of 3) and overweight financials (by a factor of 2), compared to the S&P, over time, I noticed my portfolio tracked the S&P VERY closely, so after watching and tracking it for about 6 weeks, I initiated a position as a "hedge".

Being a "double short", SDS is VERY volatile, so I've always used limit orders to buy or sell. Being self-employed, I don't have the luxury of sitting at a computer all day, watching the market. I don't try to make money on the intraday wiggles....watching the intermediate term trends, instead.

Long story short, my portfolio is only down about 3%, ytd, while still generating a 9.5% yield. Good luck!!!

jan