The Importance of the Long-Short Portfolio

Includes: ITB, SDS, SPY, XHB, XLK
by: Cal Finance

In today’s volatile environment, taking directional bets is very risky. Buying a stock or an index is much riskier than it ever was. Let’s face it – the debt problems of the West are not going away anytime soon. Greece will default in three years. Portugal, Spain and Italy will continue to find it hard to borrow and this will create more problems. The sovereign debt crisis has just begun in Europe and it will make headlines for years to come. This is not a problem that can be solved overnight. The US will face this problem in years to come as well. Just like in the Greece scenario, one day investors will decide that they want higher yields on US bonds and what will follow will not be good. There are plenty of articles on the US government bond bubble and all of them are fundamentally correct. The only question is when. These debt problems in Europe and the US have the potential for something far worse than what the subprime mess created. We are not talking banks anymore, we’re talking countries. So, this leads me the important question: how does one position himself given this uncertainty.

It’s very important to be long-short with a very low net in this environment. These uncertainties and problems will continue for a long time and this means that being long only is asking for trouble. Long only works in a goldilocks environment which persisted prior to 2000, not anymore. I believe that a goldilocks scenario is a “tail” event. There is a fundamental problem in the US and Europe. We are borrowing to pay wages and the deficits are only growing bigger, a surplus looks eons away. Now granted that this was the same feeling in the 80’s, yet we ran surpluses in the 90’s. This was because of the tech boom. We are once again relying on something good to happen but it’s not something we should bank on. I am not counting on it. So until things change and we can create magic with another boom, the structural underpinnings of the US economy are not good. This may mean stunted growth, a sustained period of double digit unemployment and a struggling economy.

That is exactly the reason one must position himself long and short. This is far easier said than done but it must be done. I also understand it is not possible to take short positions in retirement accounts. The irony is that this is a safer strategy today to be long-short than being long only in a retirement account which has the potential to destroy one’s savings. Shorting is also very hard if you can’t commit time to understanding companies. I always feel short sellers are the ones who always do their homework. Also, shorting has advantages for the retail investors given that institutions can’t short, which creates an upward bias on most stocks. But shorting is also risky given the unlimited losses one can incur. That is why it is so important to diversify your shorts and to ensure your fundamental view hasn’t changed to avoid panic if the stock runs up on you.

As an example of one long-short trade I like is long XLK and short XHB or ITB, which is going long technology while shorting the homebuilders. These two are ETF’s and are diversified so it doesn’t let XHB run up on you in a crazy way. Another example could be long Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) and Best Buy (NYSE:BBY) and short MarineMax (NYSE:HZO), Brunswick (NYSE:BC) and Men's Warehouse (MW). There are plenty of ways to make such portfolios with indices, specific stocks or currencies. Creating a long-short portfolio is more complicated because there are many factors to consider such as beta, industry and factor matching. I will discuss this in my next article with several long and short ideas. I’ll also explain my thesis for shorting the homebuilders to complement my long technology play, although it might be obvious to some.

Investing today is just not what it once was. There is systemic risk that could fall upon us at any time and can clean out much of the value of our portfolios. We need to be judicious with our investments and looky beyond the very near term. The medium to long term poses several challenges to the biggest economies in the world. Hence, having a long-short portfolio today is more important than ever.

Disclosure: Long WDC, short XHB and long SDS calls