"The markets can stay irrational longer than you can stay solvent."
-- John Maynard Keynes
On the surface, shorting stocks isn't a tough concept to understand. You're simply betting the stock will go down instead of up. All you have to do is look for companies that are performing poorly, and you've got a guaranteed winner, right?
The challenge of shorting stocks is that all sorts of things can get in the way of short-sellers, many of which don't make a lot of sense. The irrational market is much as Keynes identified, and this year irrationality appears to be extraordinarily high in the market.
When terrible stocks go up
The few short trades I've made have been in companies that I think are really terrible fundamentally. This approach reduces the risk of being on the wrong side of a growth stock the market never seems to value logically, but even betting against bad companies has its risks.
Take Caesars Entertainment (NASDAQ:CZR) as a prime example in 2013. The company has lost $1.4 billion in the past year, revenue is declining, and it's drowning in debt, yet the stock is up 215% this year. In this case, investors have been suckered in by the promise of a spinoff including the company's online gaming operations, which themselves don't have any real revenue yet. I don't think the sum of the parts make any sense, but the market says differently.
Nokia (NYSE:NOK) is a similar story. The company lost $5 billion last year and has no real momentum against smartphone giants Apple and Google. But a sudden offer by Microsoft to buy its handset unit boosted the stock, killing short-sellers in the process. Is Nokia suddenly a good company? No, but that doesn't mean the stock can't go up.
Even betting against bad companies who perform terribly financially can result in massive losses for short-sellers.
Leave logic at the door
The market can be even more maddening for those trying to short stocks they think are wildly overvalued. Tesla Motors (NASDAQ:TSLA) is worth just under a third of what Ford is worth, or $1 million per car it produces each year, yet the market doesn't bat an eye at what the stock is trading for. Plus, using GAAP, the company hasn't turned a profit yet. Trying to envision how Tesla can live up to its current valuation will leave even the best investing minds scratching their heads.
Stern School of Business professor Aswath Damondaran, a well-respected mind on valuation and finance, Tweeted last week that even if "Tesla grows to have Audi-like revenues ($67 b) & Porsche-like margins (12.5%), I can't get past $70/sh." Take a look at his full argument here and see just how fast Tesla would have to grow to live up to expectations.
Netflix (NASDAQ:NFLX) and Amazon.com (NASDAQ:AMZN) are two popular shorts based on the insane valuations both companies have garnered. Neither seems to be able to make a consistent profit, and in the case of Amazon there doesn't seem to be any real desire by management to make a profit long term.
Yet both stocks continue to rise despite little earnings power. Netflix has at least made a $47 million profit in the past year, earning a 369 P/E ratio, while Amazon is losing money and still has a $134 billion market cap.
Shorting stocks based on valuation can be even more dangerous than shorting bad companies. You never know how long the market is going to give stocks that look overvalued a pass, and it's possible they'll just become more overvalued in the future, even if the value doesn't make any logical sense.
Shorting is a dangerous game
This year is showing exactly why shorting stocks is so dangerous. You have unlimited downside, and when the market becomes irrationally exuberant about an investment you can be left in the dust, even if the company is losing money or has terrible future prospects.
Fool contributor Travis Hoium manages an account that owns shares of Apple and Microsoft and is personally short shares of Amazon.com. The Motley Fool recommends Amazon.com, Apple, Ford, Google, Netflix, and Tesla Motors and owns shares of Amazon.com, Apple, Ford, Google, Microsoft, Netflix, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.