A rising tide might lift all boats, but choppy waters are bound to shipwreck dilapidated vessels. And in case you missed it, we’re sailing some choppy seas in the market.
Case in point: The VIX Volatility Index more than doubled since August 1. And 400-point swings for the Dow are commonplace again.
Now, I understand that Dr. Steve Sjuggerud revealed yesterday that when the VIX spikes, it’s proven to be a good buying opportunity for stocks. And I agree with his analysis.
But no indicator is infallible. And history doesn’t always repeat itself. Plus, the market’s still in a downtrend having suffered declines for four straight weeks.
Long story short, it can’t hurt to add some insurance to our portfolios right now. I’m specifically talking about finding a handful of less than seaworthy companies and selling them short.
To sell short successfully, though, we need to keep these three points in mind…
~ Short Selling Secret #1: Price is Never Enough
As economist, John Maynard Keynes, said, “Markets can remain irrational longer than you can remain solvent.”
So selling stocks short based solely on valuation is a surefire way to lose money. Sorry, investing isn’t that easy. It requires more effort than simply identifying the market’s most expensive stocks and then selling them short.
I’m not saying we should avoid overpriced stocks altogether. Heck no.
As you’ll recall, I panned OpenTable (Nasdaq: OPEN) in February because investors “flat out bid up the share price into the stratosphere.” But my rationale for selling short the stock went well beyond valuation, which brings me to my next point…
~ Short Selling Secret #2: There’s No Replacement for Research
As we’ve proved here countless times before, share prices ultimately follow earnings. If a company consistently increases earnings, share prices trend higher. In contrast, if a company consistently reports lower earnings, share prices trend lower.
Thus, the key to making the most profits from short selling is to be one of the first investors to identify companies with fundamental weaknesses that are likely to sap earnings.
The only problem? Sniffing out companies with an Achilles heel requires unparalleled research. And that’s because the first signs of a deteriorating business are not immediately recognizable. Not to mention, the mainstream financial press is apt to ignore any early warning signs.
Take Jim Chanos, for example. He started warning about shady accounting at Enron in October 2000. But everybody scoffed at his analysis. That is, until Enron cratered from $90 per share to about $1 by the end of 2001.
Or how about David Einhorn of Greenlight Capital? You’ll recall he started selling short Lehman Brothers in July of 2007 because his analysis revealed the company was undercapitalized. He went public with his findings in early 2008… And was skewered by the press for trying to drive Lehman’s stock into the ground for personal profit.
The rest (and Lehman) is history. Chanos and Einhorn were dead right. It just took some time for vindication, which brings me to my last point…
~ Short Selling Secret #3: Patience is a Must
If we’ve done our research and know we’re right, the toughest part about selling stocks short is waiting around for the rest of the market to wakeup to the same reality.
OpenTable serves as a perfect example, again.
When I first wrote about the stock, it was trading for about $84 per share. But the stock still went on a tear, rising 42% to a high of $118.66 before anyone wised up to its fundamental flaws.
Today, the company trades for around $58. Or about 30% lower than when I originally recommended selling shares short. Thus, earning those profits required serious patience and intestinal fortitude.
In my experience, that’s par for the course when it comes to short selling. To be profitable, you need to be patient.
Bottom line: Time and time again research demonstrates that stock declines occur three times faster than stock increases, on average. So if this market really rolls over, you’ll want to make sure you have some choice short positions in your portfolio. After all, as they say, “An ounce of protection is worth a pound of cure.”
Ahead of the tape,