Discussion on Shorting the Market
Once you’ve begun to understand the basics of the stock market, it starts to become clear to you when the market is generally overvalued or undervalued. This is a great sign in your development as a savvy investor. Then you start to think you can start shorting the market or overvalued stocks and make a grand profit. I know because I’ve been there.
Shorting the market is a great idea but a poor investing practice. There’s a lot of risk for small gain potential, time turns against you instead of for you, and you can be wrong for a lot longer than you realize. Again, this contrarian attitude is a great thing to have. But you must guard against its pitfalls. Here’s the question that prompted this fantastic discussion by a VTI Spreadsheet client, Benoit D.
I appreciate the time and effort you put in all your mails. I really enjoy them.
Do you think it’s wise to take a position in shorting the index S&P 500? For example: ProShares UltraShort S&P500 (ticker SDS). I think the market is really overvalued for the last year (maybe even longer).
Or do you think the market will continue to rise over the next few years?
You’re right about the market. I agree that it is overvalued and has been for some time. However, if I were in your shoes I wouldn’t short the market. Let me explain why.
The basic premise behind buying a stock that makes it so attractive is that there are two possible results in the most extreme of circumstances. The worst result is a stock that goes bankrupt and you lose all of the money you put in. On the flip side, the amount of money that you can earn is unlimited, with it being very possible that you earn much more than you put in.
Compare that to shorting a stock. The risk and reward profile for shorting a stock is reversed. Now you can lose an unlimited amount of money were the stock to keep rising. At the same time, your upside is capped, as a stock can’t ever trade below 0.
Since shorting a stock is again the opposite of going long, someone shorting a stock must pay out dividends to the owners. So instead of collecting interest and compounding it in a slow and steady way, the short seller is paying out interest. This puts the short seller on a strict time limit, with quick profits needed to mitigate eroding losses.
You also have to consider the requirements for short selling. Because any stock has the potential to rise very quickly, your broker needs to cover their downside in case the amount you owe surpasses the collateral or initial investment amount you made. So, you have to open and maintain a margin account which the broker can pull from during periods of short squeezes. I’ve written before about how I’m adamant against investing with debt, and many great investor billionaires have also abhorred the idea of using debt to build wealth.
Top that all off with the fact that in the case you do get squeezed, the broker will make what’s called a margin call. A margin call occurs when a stock has gone so far against the short seller that more collateral is needed to keep the trade alive. So you must come up with cash right away if you want to keep funding a losing trade. That you means you could very we’ll be completely right about a situation or overvaluation, but if you don’t have enough capital to stock it through initial losses you’ll lose anyways. There’s actually a lot of examples of this happening to people, and it takes many of these losers before any big winners like Michael Berry ever come about. Of course, a big winner like him is way more publicized than any of the many losers.
As if that all wasn’t reason enough to not short a stock, you also have to consider the irrationality of the market. We don’t have to look very far back in history at all to understand that fear or greed can grip the market for years. I mean, I remember people saying that the market was overvalued in 2013 and that a bear market was just around the corner. They were right at the time, the bull market had already run extremely far up, but even today it continues to climb and become more overvalued. Anyone who took a short position back in 2013 has been absolutely annihilated since then.
A book like Irrational Exuberance will also reveal the madness of the crowd and how they prop up bubble stocks to extreme proportions. This isn’t an isolated feature of the stock market, people have been creating bubbles since the tulip craze of the 1600s and probably many times before that. It’s actually base human nature that we are talking about here. If you look at any of the big bubble stocks today, NFLX AMZN TWTR TSLA… Some of those stocks have doubled, tripled, or have gone even higher since time periods where they were very overvalued, valuations at absurd proportions like a P/E over 100 or negative.
I’ve heard the phrase “the market will stay irrational longer than you can stay solvent”, and if I think about it now that sounds like a direct reference to shorting. The prevalence and preoccupation with growth stocks and trendy business catch words like “Elon Musk” and “new economy” prove this point to me and deter me from ever wanting to short a stock based on valuation, ever. The funny thing is that those trendy buzzwords and growth valuations have been seen in every recent bull market we’ve had. The evidence is right there before our eyes with a quick Google search or search on my blog, but (enough) people never learn.
As far as the idea of shorting anything in general, the only way I could perceive doing something like that is with an obvious value trap with a company that is drowning in quick sand. In talking about a super high value trap indicator score, negative earnings, debt coming out of their eyeballs, etc. Even then though, I’m not sure if id do that today because of the risk reward profile of shorting and the reliance on market timing. Don’t get me wrong, I’m extremely confident in my skills even to the point of obnoxiousness, but even I have the humility to understand that I can’t win in a market timing game.
I don’t want to speculate about the market’s direction in the next couple of years, but I did address some facts about the Federal Reserve in December’s eLetter issue that will likely have an influence on the market for the foreseeable future.