With Europe on the ropes and the U.S. economy in shambles, it’s important to remember that there are two sides to every trade. Tapping into upward momentum alone is not the only way to profit. Markets can and do head south on a regular basis. Investors who fail to grasp this are leaving a lot of money on the table.
Nobody knows for sure. But stories about famous traders like George Soros who broke The Bank of England and reportedly scored a cool $1 billion profit abound.
People also speak in awe of John Paulson who made billions off the housing crisis and about Doug Kass of Seabreeze Partners who is about as gutsy as they come when it comes to making hay when the sun doesn’t shine.
If you’ve never heard the term before — and many investors still haven’t — shorting stocks involves selling stocks before you buy them and profiting as they drop.
Why would you do that?
Shorting overvalued stocks can lead to profits when others are crying in their beer. It’s a way to keep you fully invested or otherwise in the game, especially when the markets are as unsettled as they are right now.
But you have to be careful. Despite the fact that shorting stocks can be a quick path to riches, not all stocks are the same when it comes to betting against them.
In that sense, short selling (at least the way I encourage investors to practice it) is no different than regular upside investing.
You want to diversify your holdings and use very strict risk management to control your exposure by not having more than 2.5% of your assets in any one position or 20% of your holdings in any given sector.
You want to short stocks in conjunction with the rest of your holdings, not in lieu of maintaining a properly concentrated portfolio. Despite what you may think, shorting stocks is not a game for market-timers or an exercise in timing.
As for how you select your target, that’s not really different either.
How to Find Short “Targets”
For example, you don’t ever want to bet against a stock just because it’s expensive or even overvalued. Instead, you want to find a compelling reason for failure or a lower valuation.
I laid out seven of them last March when I suggested that Apple (NASDAQ:AAPL) may be the short of a lifetime rather than the next best thing since sliced bread.
At the time, I reasoned that:
- Apple was a bubble based on technical parallels to the Nasdaq bubble of 2000.
- Its products were faddish and driven by new product launches rather than sustained production.
- A change in leadership may produce slower or greatly varied product development.
- Short interest was an ultra-low 9.8 million shares; it seemed logical to take the other side of the bet if everybody was so bullish.
- Analysts were almost uniformly bullish which is a very bearish sign, according to past corrections.
- Apple’s profit margins were disproportionately high in its industry.
- A carrier failure or subsidy change may soften the company’s fundamentals.
Apple rose a bit further to a peak of $644, then fell 17.68% over the following few weeks to $530.12. It’s still down today at $576. And yes, I think it will fall further in case you’re wondering.
Other negative attributes I look for include insider selling and problematic accounting. Both can be hard to spot in a timely fashion but that doesn’t mean you shouldn’t look.
Armed with a good dose of skepticism, you can find companies that are likely to fall apart in pretty much any market anywhere in the world if you look hard enough.
Take action on strong up days when the believers are pushing the stock for all it’s worth – every stock has them. Some brands like Apple, Harley Davidson (NYSE:HOG) and Facebook (NASDAQ:FB) , for example, are particularly well defended by brand loyalists.
That’s why you’ve got to have a thick skin when you are shorting stocks because you’re essentially betting against the success so many people hope for.
Your friends will accuse you of being un-American or a vulture – mine certainly have over the years. Worse, any butthead with an Internet connection can take a potshot at you in today’s socially driven media age.
Stick to your guns. They’ll get over it when they figure out how much money they could have made and how they can get in on the action.
Where to Find Good Short Candidates Right Now
Here are four industries I believe are ripe for the picking at the moment:
1) European Banks
I know that everybody is looking for profits in the face of unprecedented government meddling but the fundamentals do not bear this out. The biggest banks are under the microscope at the moment and face the most hostile legal environment they’ve seen in years. The ESM and ESFM don’t have enough money and the bailouts are simply propping up a house of cards that will ultimately come crashing down.
Most have had the starch beat out of them already so wait until a new stimulus program is announced then consider shorting Italy’s number three bank, Monte dei Paschi di Siena. It’s reportedly 3 billion euros short of capital and has more than 26 billion euros in exposure to Italian government bonds. Deutsche Bank’s (NYSE:DB) Italian and Spanish Units may be 14 billion euros short of what it would need to weather a euro breakup or break down.
2) Social Media
Facebook is the poster child for everything that’s wrong with this industry. Nine hundred million users or not, if you can’t monetize their eyeballs you’re gonna get Zucked. That stock is worth $7.50 at best. Zynga (NASDAQ:ZNGA) and Groupon (NASDAQ:GRPN) come to mind, too. So does Jive Software (NASDAQ:JIVE).
3) Consumer Electronics
Sony (NYSE:SNE), once a world- class operation and leader in everything from consumer electronics to games, financial services and films, is getting badly beaten. Very few analysts see anything resembling competent management, let alone an Apple style product set that could turn this company around before Godzilla comes out of the Tokyo Bay again.
4) Alternative Energy
The first rule of any profitable industry is that it’s able to stand alone on its own merits. Therefore, any heavily subsidized industry is suspect, particularly if they’re the recipient of mollycoddling Federal initiatives. Right or wrong, green energy subsidies are going to be cut when the government runs out of money or actually investigates the questionable loans that it’s made in the name of progress. So while we may not have another Solyndra yet, it’s only a matter of time before we do.
Those are mine. Let me know what you’re shorting and why.
And remember, there is opportunity in every market. You don’t have to be long to earn a profit.