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Do Short-Sellers Have It Wrong Again This Time?

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As the stock market rebounds from its recent correction, short-sellers are back in force. But will they prove as mistaken about the market's future prospects as they were last year?

A recent look at short-selling activity on the New York Stock Exchange revealed that June's figures exceeded those from September 2011, according to Bloomberg. Both last year and the year before, though, the stock market has rallied after short-selling activity has peaked, with last October's big rebound in stocks being a powerful example of how the market can thwart pessimistic investors. Will the same thing happen this time around?

Is shorting wrong?
Short-selling is a tricky part of investing. Many see the practice as somehow morally wrong, as the fact that you're trying to make money from declining stock prices rather than advancing ones means that you're essentially rooting for failure.

Yet short-selling fulfills an important function in the market. Without short-sellers, unchecked optimism could inflate asset bubbles to a far greater extent than we already see them. Short-sellers point to profits from shorting Enron, the subprime mortgage market, and fraudulent Chinese small-cap stocks as victories for the practice, as the research they did unearthed concerns that later proved all too true in many cases.

Can shorts get it right?
The problem, though, is that just like any other group of investors, short-sellers don't always get their calls right. When short-selling activity in a particular stock gets too prevalent, it can leave short-sellers exposed to a short squeeze, where bullish investors bid up shares to put pressure on short-sellers to cover their positions, pushing share prices up even further and creating a feedback loop.

Short squeezes can happen even when the fundamental argument behind a short position seems bulletproof. For instance, PulteGroup (NYSE: PHM  ) has soared, tripling since October despite the fact that it's only now recovering enough from the housing bust to return to profitability.

But when shorts are right, they can be really right. The recent experience of Netflix (Nasdaq: NFLX  ) and David Einhorn's vocal call against Green Mountain Coffee Roasters (Nasdaq: GMCR  ) provide great examples of situations in which short-sellers' theories about the companies proved correct, and those who shorted the stocks at their highs made plenty of money.

The key, though, is "at their highs." Plenty of short-sellers targeted Netflix and Green Mountain long before they reached their peaks, accumulating huge paper losses before finally being proven right. Given the pressure that gains put on short-sellers, many of them likely closed out of their positions at a loss before the plunges finally came.

It's different this time
One thing the short-sellers have going for them this time around is that the market hasn't tanked. The S&P 500 finished June at 1,362, within a few percent of a multiyear high. That stands in stark contrast to last September, when the S&P closed fully 17% off its summer highs, and suggests that stocks may have room to fall.

However, many are expecting further action from the Federal Reserve to boost the economy and asset prices. If that happens, short-sellers could once again be the victims of lax monetary policy.

Don't bet the farm
One thing you should especially watch out for is using leveraged bear ETFs to make short bets. If you're only planning to stay in a trade for a short period of time, then such ETFs can make good plays. But over longer periods of time, ProShares UltraShort Silver (NYSE: ZSL  ) and UltraShort QQQ ProShares (NYSE: QID  ) have failed to deliver the gains investors would have expected during downtrends for their respective target sectors.

Short-selling is itself a contrarian phenomenon, but as we've seen, being contrarian about those contrarian bets can work out. By itself, though, high short-selling activity can't predict the near future, and there's no guarantee that stocks won't actually do what the shorts want them to do this time around.

Short-selling can help you make money in bad markets, but over long periods of time, you should also make sure you make some smart plays on the long side. Get a few promising ideas from the Fool's special report: "3 Stocks That Will Help You Retire Rich." Get your free copy today while it lasts!

Fool contributor Dan Caplinger rarely sells short, but he's not hesitant to sell in the right situations. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Netflix and Green Mountain Coffee Roasters. Motley Fool newsletter services have recommended buying shares of Netflix and Green Mountain Coffee Roasters, as well as creating a lurking gator position in Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never gets it wrong.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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