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Can You Short in a Bull Market?



September 21, 2010 – Comments (12)

In a previous post, zloj and I had a bit of a back and forth on the topic of TMF's new shorting service. The issue was continued on zloj's blog, where our exchange was reposted with zloj's emphatic thoughts that the service would be a miserable failure since the market is headed for more gains.

I actually don't disagree on that last point. So what gives? Can you still short in a bull market?

Since the Big Short will be taking a shorter time-frame on its moves, I stuck to one-year periods for what I looked at to be somewhat comparable.

Certainly the worst time period to check this against would be the recent bull charge off the recession lows -- that is, March 2009 to March 2010. And the results come out as might be expected -- the S&P 500 was up 52% and among stocks with a market cap of $250m or better, 92% were in the black. Ouch.

But that's pretty extreme. I don't see that kind of move ahead, and it doesn't seem like zloj, or anybody else with their head on straight sees that kind of juice in the year ahead.

So I looked at another year period that was also very bullish, but not quite so -- August 1998 to August 1999. During that stretch the S&P was up 34%. Of the stocks that were $250m or larger, 62% posted gains. Now that means you would have had a better chance of picking a gainer than a loser, however, it also means that a chimp with darts would have had better than a 1/3 chance at picking a short that would make money. I could only assume that a seasoned short-selling investor would have a far better chance than that. And that's during a particularly strong bull run.

Looking at one more positive stretch for the market, but not nearly as positive as the other two, I also pulled up the results for January 2005 to January 2006. The market gained, but only about 3%. During that year, you had a 53% chance of picking a stock that was in positive territory. In other words, your chances of picking a money-making short were nearly the same as a flip of a coin. 

And of course none of this covers what happens if you decide to short against an index to make your returns from stocks that simply underperform that index. That changes the math considerably. Now during even the 3/09 - 3/10 period, you had about a 50-50 chance of picking a stock that underperformed. It was roughly the same during 2005. Interestingly, during the 1998 period, you had a 70%-plus chance of finding a stock that underperformed the S&P's 34% gain.

The bottom line is that I don't think you need to be a bear to be interested in adding shorts to your portfolio. Personally, I'm not really bearish at all, but I know that there are companies out there that are doing things that could lead to a stock-price tumble whether or not the market is charging forward.

Now will Big Short deliver incredibly amazing performance? Only Miss Cleo knows that. But I hardly think it's doomed just because the market may have some positive momentum ahead.


12 Comments – Post Your Own

#1) On September 21, 2010 at 7:17 PM, talotu (< 20) wrote:

This is what I found so objectionable about the Big Short marketing (and the Pro marketing as well where they talk about 93% of positions being closed for gains), the implication that success rate is meaningful.

In any period of time more stocks will underperform than overperform, that's what happens when you have a lognormal distribution of results.  As it turns out, you'd expect more underperformers during raging bull markets, that's the nature of the distribution.

What also happens when you have a lognormal distribution is that on average the winners will outperform by more than the losers underperform, thus resulting in a net effect of ..... wait for it.... 0.

Going long random stocks and shorting a market index will result in more losers than winners, but your expected value would be $0 - transaction costs.  

 Going short random stocks and going long a market index will result in more winners than losers, but your expected would still be $0 - transaction costs. 


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#2) On September 21, 2010 at 7:22 PM, starbucks4ever (98.98) wrote:


That's a good summary. Plus, there are those nasty margin calls. 

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#3) On September 21, 2010 at 8:07 PM, TMFKopp (98.93) wrote:


"Going long random stocks and shorting a market index will result in more losers than winners, but your expected value would be $0 - transaction costs.  "

This is really what you've got for me? Want to tell me about the EMT next?

The service will only be of value if the advisor is good enough to find positions that will produce attractive returns. The point I was making isn't that you should randomly go out and short stocks, rather, that even in a bull market you can find plenty of shorting opportunitites.



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#4) On September 21, 2010 at 8:11 PM, TMFKopp (98.93) wrote:

I'll also throw out that a lot of the dicussion seems to hinge around a general feeling of short versus long as if the existence of a shorting service means that you have to choose one or the other...

Maybe if you're a macro-only investor that's the case -- either you're bullish and you're going long or you're bearish and you're shorting. If you're looking at businesses at an individual level though, having both play nice in a single portfolio makes more sense.

As in: I look at company A, it's got a solid business, stand-up management, a track record of success, and a great balance sheet. I'm going to go long. I look at company B, it has a CEO that has a history of failures in his past, the balance sheet is horribly over-levered, the business model is questionable at best, and it appears the company is forcing product on its customers to be able to show revenue growth. I'm going to go short.


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#5) On September 21, 2010 at 10:26 PM, starbucks4ever (98.98) wrote:


The point is that you don't have the same margin of safety. With longs, you can throw darts at random and still win statistically. When shorting, you don't have that tailwind. And people who don't benefit from tailwinds can be expected to perform worse. It's a simple law of statistics.

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#6) On September 22, 2010 at 12:58 AM, TMFKopp (98.93) wrote:


"The point is that you don't have the same margin of safety."

A broad, statistical MOS? No probably not most of the time. But what I'm more concerned about is if I'm able to find individual short ideas that have their own margin of safety.

"people who don't benefit from tailwinds can be expected to perform worse"

Hmm... Yeah, I can agree with that. But I sure hope John isn't throwing darts at a dart board either. 

If your point is that in an upward-moving market it's going to be more difficult to find successful shorts than successful longs, then yup, I'll agree to that too. But higher difficulty doesn't equate to impossibility.


But more importantly I don't want to overlook the big picture here. As I have mentioned a few times, I'm not bearish on the overall market and I think investors can do well by buying a variety of stocks right now (I personally like large-cap dividend payers at the moment). The vast majority of my portfolio is going to stay long... unless perhaps the market makes some sort of wild and fast upward movement, and even then I'd probably be more just out of the market that short.

What I like the short idea for is providing a different type of exposure to my portfolio. In a similar way, I have part of my portfolio invested in what I call "Graham stocks." These are mostly ugly little stocks that are trading either well below net current asset value or just well below book. I have no intention of directing my entire portfolio towards these types of stocks, but they move differently from the rest of my portfolio and provide some different exposure.

Plus, I think looking at things many different ways makes me a better investor. Digging into the Graham stocks has ceratinly made me look at things differently, and beginning to research short ideas has done the same -- maybe more so. Learning to be critical of accounting practices and getting practiced at where to look for funny business in company filings will only help me better research my long ideas.


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#7) On September 22, 2010 at 1:00 AM, TMFKopp (98.93) wrote:

More to the point... if you put me to a decision and I could choose just going short or long, that's an easy decision -- I'll pick long every time.

But that doesn't mean that shorting doesn't have its place.


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#8) On September 22, 2010 at 12:53 PM, talotu (< 20) wrote:

I don't beleive in EMT, but I do beleive in randomness.

When you tout a statistic that can be explained by randomness, it's not a very valuable statistic.




It's easy to get fooled by statistics, in fact it's often hard not to be fooled.  I just find it objectionable to use misleading statistics for marketing. In that way TMF is no different that

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#9) On September 22, 2010 at 5:12 PM, TMFKopp (98.93) wrote:


Hang on just a second... what's your point?

Because my point was simply that it's possible to find worthwhile shorts even while the market is going up. You don't seem to disagree with that.

I'm not saying that somebody that gets 50% of their shorts right when 50% of all stocks are underwater is anything special, I'm just saying a person picking shorts in that market does have a chance of doing well.

The rest of it boils down to skill.


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#10) On September 22, 2010 at 6:27 PM, starbucks4ever (98.98) wrote:

An excellent observation, TMFKopp. Skill is certainly a good thing to have. But does the average Motley Fool newsletter team possess this kind of skill? Last time I checked, most newsletters performed in line with the benchmark index, give or take a few percent. The two exceptions are Stock Advisor and Rule Breakers. I am not subscribed to either of them, so correct me if I'm wrong, but I claim that their success hinges upon 4-5 picks that became multibaggers. Do you see what I'm getting at? Without exploiting the tailwind of potential multibagger returns, the average Fool team does not know how to beat the index. Why should I assume that the Big Short team will have the stock-picking skills that other teams don't have?

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#11) On September 23, 2010 at 1:42 AM, TMFKopp (98.93) wrote:


Most newsletters are ahead of the indexes, Stock Advisor and Rule Breakers, as you note, more so than most of the others.

Running quick stats on SA, the gains seem pretty well distributed, though there have been some big homeruns on that service.

As for RB, to dismiss the few huge multibaggers it's had is to not really understand the nature of the service. RB is basically on the venture capital model -- it recommends up-and-coming, potentially fast-growing companies that could really take off and hit the moon. As in the VC business there are a bunch that go nowhere or are disappointments and there are a few that actually do hit the moon. 

 "Without exploiting the tailwind of potential multibagger returns, the average Fool team does not know how to beat the index."

Other than that Mrs. Lincoln, how was the show? Are you against the newsletter teams finding multibaggers?

Of course, Big Short will be different than that because they'll ideally be picking a lot of smaller winners -- there's no opportunity for multibagger returns when you short unless you start doing more than vanilla shorting. 


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#12) On September 23, 2010 at 7:01 AM, GraemesPSP (99.42) wrote:

Regarding the 98-mid 99 period, as a short seller that was probably my most profitable period.  Despite the markets upward bias, there were a huge number of over-valued or purely fraudulent companies (as well as reg-S downward spirals) which made finding shorts quite easy.  And as opposed to October 99 - March '00, the shorts actually did drop.

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