cbaines2 (98.89)

The Bullish Case for Short Selling

October 04, 2010 – Comments (4) | RELATED TICKERS: MSFT , CSCO , XOM

It is taken as a given that if you are short selling, you must bearish. This is does not need to be the case. In fact, shorting stock can be one of the most bullish activities you can engage in.

No, I'm not on crazy pills. Let me explain...

Right now I look at the S&P 500 as a whole as being cheap. Not just cheap, but very cheap indeed. As the Fool has reported countless times, corporate profits now exceed pre-recession levels. The top-heavy index is dominated by high quality businesses (such as Exxon and Microsoft) that trade near 10x free cash flow. It seems highly likely that the S&P will perform well over the next 10 years or so.

But there is a flip-side to this bullishness that is often forgotten: If I expect returns for the index as a whole to be excellent, then it stands to reason that beating the index simply on the long side may prove difficult. During a strong bull market, such the one in the 1990's, the index made prudent long managers look foolish (and not in a good way). It was in the eventual bear market that active long managers (such as Bruce Berkowitz at Fairholme) made a strong case for themselves.

In fact, from 2000-2010 value investors such as Fairholme made incredible profits on the long-side...during an extremely bearish decade. The bear decade was the perfect backdrop for demonstrating a value investor’s skill. They could use their skill to add value because the index itself was so terribly constituted (think of Cisco's year 2000 dominance of the S&P 500 at 130x earnings).

Now, here's the kicker: If the index today is as wonderful a portfolio as I think it is, then it stands to reason that  finding stocks that will under-perform it should be a realistic task. (Index leadership is often narrow. In 1999, for example, most the performance was led by small group of stocks.)   Earning alpha on the short-side should be a fruitful enterprise when the index is such a hard bogie to outperform. All you need to do is buy an index ETF, short a stock that will under-perform the index, and then profit.  Bull markets are also volatile, so having gains on the short side can provide additional ammo (buying power) during the inevitable corrections. If the shorted stock doesn’t simply underperform, but actually goes down in value, then additional performance is added that otherwise wouldn’t be there.

If you plan on hedging any shorts with long index ETF (as the Motley Fool advises)  - then adding value through shorting should be easier, not harder, during a bull market.  As for me, I’m going to start adding underperform picks to my CAPS account.