Short Sellers Have Hard Year as Market Booms

The past year has been tough on the market’s hardest-core contingent of pessimists. These investors, known as short sellers, have lost a fortune as the Dow Jones industrial average has relentlessly climbed to new highs.

That’s because short sellers bet against the market by selling borrowed shares of stock in the hope that they’ll be able to buy back the shares at a cheaper price in the future.

Where most market analysts like to look for positive stories about companies with great products and strong potential, short sellers revel in tales about companies ready to be sunk by a bad economy, declining earnings and crushing debt.

By most measures, 1991 should have been a short seller’s heyday. The economy was rotten. Company earnings were dismal. Layoffs were rampant. And bankruptcies hit all-time highs.

Despite the bad news, stock prices soared and short sellers got kicked in the teeth. On average, short sellers lost 33% of their money, said Harry A. Strunk, a Palm Beach-based investment consultant who tracks short sellers. It was the first time short sellers had a down year since Strunk started keeping records in 1983.

“We were absolutely right about the economy last year, and we lost our fannies,” complained Steve Kibbey, vice president and portfolio manager for Centurion Trust Co. in La Jolla. “The problem is that we focus on fundamentals. And sometimes fundamentals aren’t enough.”

Sometimes the prices of all stocks--good and bad--fall without good reason. Conversely, the prices of all stocks--including rotten ones--occasionally all rise at the same time, Kibbey said. Kibbey is convinced that’s what happened last year.

However, some maintain that 1991 was a signal that short selling no longer works as a strategy. Short sellers control a fraction of the money that more optimistic money managers invest. So some believe that the optimists can simply gang up on the pessimists and drive them out of business.

There are about 17,000 “buy side” investment managers versus about 24 who specialize in short selling, Strunk said. If enough “buy side” managers decide to buy a stock that’s troubled, they can squeeze out the short sellers, he said.

Still, that involves a lot of risk and an unusual amount of cooperation on the part of investment managers. Most short-selling experts believe that such a scenario unlikely.

Indeed, some believe that the potential for short sellers has never been better.

Companies are just now seeing their February sales and earnings figures, which are sure to be disappointing, noted Michael Murphy, editor of the Overpriced Stock Service, a short-sellers’ newsletter. And with the stock market near all-time highs, some believe that the market is ripe for a fall.

“Those who stay alive through this bad market are going to have the opportunity of a lifetime,” Kibbey maintained.

Those who want to try their hand at short selling have three basic ways to do so. They can invest with a firm that specializes in short selling. But usually these firms require you to invest upward of $100,000. You can short sell on your own by simply calling your broker. Or you can buy put options, which are options to sell a company’s shares at a set price at a particular point in the future.

If you short sell through a broker, you will usually need to open a margin account. You must also monitor your investment carefully. Why? If, for some reason the value of the shares you shorted starts to climb rapidly, you could lose several times your initial investment.

Remember, when you short sell, you sell somebody else’s shares. You must pay back that loan by buying the shares in the future. Theoretically, there is no limit on how much you might have to pay. You may have shorted a stock at $10 and had to buy it back at $30. Murphy suggests that you get out when you take a 25% loss.

The third way to short sell is to buy put options. By buying a put, you limit your possible loss to the amount you invested, but you increase your risks in other areas. Unless the company’s stock price drops before your put option expires--which could be in a few weeks or in a few months--you will lose money. The other short-selling strategies tend to give investors more time.