Short-selling is a necessary component of the market. Without it, stock prices would reflect only optimism -- a dangerous prospect, in extreme quantities. However, I can't really recommend shorting to individual investors, and I don't practice it myself. It's a quick and easy way to lose your shirt.
Fortunately, I've found an easy way to test my short theories. Look no further than my record in Motley Fool CAPS for a lesson in how dangerous it can be to be wrong (or early) when shorting stocks.
Lessons in sensible shorts
Investors, pundits, and corporations like to villify the act of short selling, but smart short sellers often uncover danger signals in companies. Enron is one good example. Michael Lewis's new book, The Big Short, also chronicles how some folks saw the signs of the housing bubble, even as too many players were locked in boundless optimism. Those who realized the complete reality disconnect of the bubble shorted it and profited hugely.
Always be wary of those who try to blame shorts for any bearish drag on a company's stock; that pessimism may be rational. In March 2008, a representative of now-defunct Lehman Brothers said: "There are a lot of rumors in the marketplace that are totally unfounded. We are suspicious that the rumors are being promulgated by short-sellers of our stock that have an economic self-interest." We now know those rumors were, in fact, very much founded.
This is a test; this is only a test
Investors who'd like to test out their bearish theories without risking their real money can learn some good lessons in CAPS by using the thumbs-down "underperform" button on stocks.
I've ridden out some interesting rollercoasters from the safety of our online investing community. Years ago, I found myself hundreds of points in the red on Crocs (Nasdaq: CROX ) , which looked like an overpriced fad stock, but kept zooming higher. When Crocs' problems finally came to light, I was able to close the pick with a positive score. (At the moment, I'm down more than 200 points on a subsequent underperform call on Crocs. Even though Crocs seems to have gotten itself off the endangered species list, I'm still skeptical that it can ever manage the growth of yesteryear.)
A rally like last year's can also illustrate how difficult short-selling can be when optimism runs rampant. Abercrombie & Fitch (NYSE: ANF ) still faces major challenges, and remains mired in shareholder-unfriendly behavior, yet its stock has soared 106% since my "underperform" call in December 2008.
One of my biggest stinkers is an underperform on Limited (NYSE: LTD ) , which I examined in March, noting a high debt load, fewer eggs in its basket of retail concepts, and flagging revenue. It's up 233% since I put the red thumb on it in December 2008.
That hasn't stopped me from trying again. We'll see how my very recent underperform call on BP (NYSE: BP ) goes. Given its shameful response to the Gulf Oil spill, and the specter of huge and increasing liabilities and regulatory scrutiny, I decided to go ahead and put a red thumb on the stock, even though it's already lost about a third of its market value. Some observers insist it's now cheap, but I'm not convinced, and I don't think management's actions or attitudes bode well for long-term investors.
Proceed with caution
I've had some red-thumb victories in CAPS, including still-struggling Borders Group (NYSE: BGP ) . But as my imaginary shorting catastrophes sugges, with real-life capital, individual investors truly risk losing their shirts with shorts. You might not even be wrong -- just early, or at the mercy of a rally driven more by hope than by reality or honest fundamentals.
And of course, if you're long, a stock can only go to zero. In theory, losses on a short can be infinite. Investor, beware.
What do you think of short selling? Fire away in the comments box below.