Thursday, June 15, 2006

Is Short Selling Un-American?

I've been bearish on the US stock market for a few months now. Even after the latest 10% slice in the NASDAQ index, I still feel nervous about the near-term prospects of the market as a hole. Interest rates continue to rise, oil prices are at record highs, political turmoil is not going away, budget deficits continue to inflate, and the US trade deficits break records with every passing quarter. But worst of all, in my opinion, is the inevitable housing crash. Keep in mind that housing construction & related industries employ nearly 10% of workers in this country!

Is anything going right?

All this negativity led me to a few interesting "Bear Funds". These mutual funds perform well as stocks decline. The most interesting appears to be the Leuthold Grizzly Short Fund. It's the only current mutual fund that has short positions in 100% of its holdings. As you might imagine, the fund has not performed very well the last few years since the market has recovered from the internet bubble of 2001. But this could be the perfect hedge against a declining stock market for the next couple years, or in any market for that matter.

The largest bearish fund is the Prudent Bear Fund. Similar to the Grizzly Fund, it also engages in some short selling, but not exclusively. Prudent also holds futures & options contracts to profit from market declines. These activities have led to positive gains even during the last few years of the bull market.

But short selling is not as accepted of a practice as it used to be. What was already a difficult and sometimes gut-wrenching strategy has only gotten harder in recent years. Nowadays, more of the companies that short sellers target are fighting back with lawsuits. They also mount sophisticated public relations campaigns against shorts.

And if that weren't enough, there's a new crop of newsletters designed to "squeeze" short sellers. In a short squeeze, investors aim to buy so much stock that the supply used for borrowing dries up and the broker recalls shares already lent out. To return stock, short sellers have to buy them back, forcing the price up. As the stock rises, it can spur other shorts to have to cover their positions, fueling further gains.

Is this criticism warranted? Not at all. It may seem Un-American to profit from a stock's decline, but short sellers help keep valuations of stocks accurate and ensure that capital is allocated more efficiently to the most upstanding companies. There's usually a reason why a company is being heavy shorted: because short sellers see problems on the horizon that the company's investors do not. Enron was heavy shorted before it began its implosion. (OSTK), one of the companies that is suing its shorting counterparts, has been struggling to keep up with its lofty projections, yet continues to blame the short sellers for its stock's decline.

But until this bad stigma passes, it may be a little more risky to invest in these Bear Funds.


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