The pitfalls of short-selling

By Bill Fleckenstein

In my daily column on my Web site last Tuesday, I sketched out a road map for earnings season. It read:

"I had established a couple of shorts last week and was chased out, but yesterday morning I re-established them and was feeling a little nervous. But my concerns have abated somewhat today. I have no idea if this will work, but here is my tentative game plan at the moment: to put out shorts selectively through earnings season -- having too much exposure would be dangerous, due to the volatility of the tape and the unpredictability of what the money printing might bring -- and then, coming out of earnings season, to get long selectively."

Just one day later, based on the collective behavior of several stocks, including certain tech stocks, I was compelled to scuttle my plans.

Micron: Keep back 200 feet

Of particular note was Micron Technology (MU, news, msgs), which said it intended to raise $450 million in stock and senior convertible notes. One of the most prodigious serial destroyers of capital outside the financial area -- excluding, perhaps, Coeur d'Alene Mines (CDE, news, msgs) -- Micron finds itself in the position it's in because of too much capacity.

I don't know how giving Micron the capital to create more (or potentially make acquisitions) will alleviate the problem. But when Micron can raise money, that speaks volumes about the appetite for speculation and is a major caution flag for potential short-sellers.

(I had nicknamed Micron "the flying pig" during the late-1990s stock bubble because it often went berserk in defiance of the fundamentals. My rule was that when the stock was soaring, it wasn't safe to be short anything, because the action in Micron proved that pigs could fly.)

The action in Juniper Networks (JNPR, news, msgs) also serves as a warning. Despite having reduced its (already-lowered) revenue forecast quite substantially, Juniper saw its stock pop 10% Wednesday. There was nothing good in the company report. But not to worry: Juniper assumed that it'll make up the revenue shortfall on the margins side. I suspect that isn't the case, which explains why I am short Juniper. But the fact that the stock soared, after having been firm already, is just another demonstration of how difficult short-selling can be.

Short-selling: What's in a name is not enough

Delving into the topic further, one thing that most people probably don't appreciate about short-selling is that it's not sufficient to have the right names. Managing the positions and managing the portfolio are perhaps several times more important.

For example, if in 2008 two people -- one experienced at short-selling and one a novice -- had shorted the same four or five stocks (stocks that ultimately "worked"), their results would likely have been radically different.

Part of that is because as your positions start to work to your advantage on the short side, you must keep up your exposure, and the potential for doing that at the wrong time is quite high (which can lead to big whipsaws).

Further, one tends to make "chunks of returns" in a short period, and that necessitates putting positions on and taking them off. That's different from the long side, in which management of your positions does not have a huge impact on your return.

Continued: More thorns to sidestep

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