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Jesse Livermore made $100 million in the Great Crash of 1929 by being short the market. Shorting, or borrowing stock and selling it in the expectation it can be bought back more cheaply later, was viewed as unpatriotic, and Livermore was pilloried in Congress.
Shorting is still regarded as verging on contemptible. You can't do it in government-regulated accounts like IRAs and 401(k)s. But it's still a great way to make money when everybody else is losing it -- and right now, a lot of us are losing it.
Rich investors hire experts to do their shorting for them through hedge funds. They've pushed assets of these portfolios up at a 15% annual clip in recent years to more than $1.2 trillion. But those of us who can't meet a hedge fund's million-dollar minimum have to look elsewhere.
What we've found is exchange-traded funds. "We've heard about institutional and even retail investors that have been building hedge fund-type strategies using ETFs," says Matt Nelson, a senior analyst with TowerGroup, a consulting firm. "Certainly there's a lot of that going on." ETF assets are up 52% in the last 12 months to $334.87 billion.
But popular doesn't necessarily mean smart. I've got a better, and safer, plan for a walk on the short side.
Dear prudence
One disadvantage of shorting is that risk is potentially limitless. Imagine being one of the poor saps who shorted Google (GOOG, news, msgs) at $150 late in 2004. A $10,000 bet would be down $25,000 and counting.More-cautious investors will be attracted to dedicated-short mutual funds, which can't go lower than zero. They also can be owned inside IRAs. The best of these, by far, is Prudent Bear (BEARX), managed for more than a decade by David W. Tice.
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Thus adventuresome investors in taxable accounts can short ETFs to make money in down markets, while less-bold and tax-deferred investors can use mutual funds. Either way, shorting can make a bear market bearable.
The MSN Money database contains a complete list of the more than 200 ETFs available. They are baskets of stocks that trade throughout the day and can be shorted like individual stocks can. Because they own many stocks, company-specific risk is minimized.
The five most actively traded ETFs are:
Nasdaq 100 Trust (QQQQ, news, msgs), a proxy for the Nasdaq 100 index.
S&P 500 Spiders (SPY, news, msgs), the Standard & Poor's 500 index.
iShares Russell 2000 Index (IWM, news, msgs), the best-known benchmark for small stocks.
Energy Select Sector SPDR (XLE, news, msgs), which tracks the energy group.
iShares MSCI Japan Index (EWJ, news, msgs), representing that nation's bourse.
If I were a gambling man (and I'm not), the ETF I would short right now is iShares Emerging Markets Index (EEM, news, msgs). As I noted in my column last week, this fund tumbled 16% in a couple of weeks last month. I expect further declines ahead.
Cubes, as the Nasdaq 100 Trust is called, were down 4.4% this year, as of May 30. The Russell 2000 fund tumbled 7.3% in the last month.
Mutual-fund investors, including those in tax-deferred accounts, can short some of these markets with inverse index funds. Rydex Ursa Inv (RYURX) and ProFunds Bear (BRPIX) perform opposite to the S&P 500. Rydex ArktosInv (RYAIX) and ProFunds Short OTC Inv (SOPIX) do the opposite of what the Nasdaq 100 does.
These companies also have leveraged-inverse index funds, such as ProFunds UltraBearInv (URPIX) and Rydex Tempest 500H (RYTPX), each of which is designed to deliver twice the opposite performance of the S&P 500.
I don't have the temperament to short, however, even through an inverse index fund, so I'm a candidate to hire an active manager. That brings me to Prudent Bear. It shot up 62.9% in 2002, when the bear market bottomed with a loss of 22.1% on the S&P 500. It has the best record in the past five and 10 years among bear funds, and is among the best in the last three. This year, although the market is mildly positive, the fund is up 11.9%.
That's mainly because Tice has had as much as 20% of assets in gold-mining stocks, although he took profits recently and cut that back to 15%. The balance of the portfolio is short.
"We're short more than 100 names," Tice says. "We've got a pretty big housing short on." Among the stocks he has borrowed and sold are Toll Brothers (TOL, news, msgs), Hovnanian Enterprises (HOV, news, msgs) and Lennar (LEN, news, msgs).
But he's broadly diversified in his shorts, from Advanced Micro Devices (AMD, news, msgs) and Amazon.com (AMZN, news, msgs) to General Motors (GM, news, msgs) and Boeing (BA, news, msgs).
A grizzly forecast
Tice is very, very bearish. "We believe that over the next three years the market is going to be down a lot," he says. How much? "I'd say 50%."He blames deficits, particularly the current-accounts deficit, which soared past 6% of gross domestic product in 2005 to a total of more than $800 billion.
The trade imbalance means the rest of the world is giving us products and we are giving them dollars. "That's a credit bubble," Tice asserts. "Policy makers are doing everything they can to keep the economy humming, and therefore they create more and more credit, and that is debasing the value of our currency. You can't borrow your way to prosperity."
Russia has expressed concerns about the dollar overtly, and the currency underlies the public blustering of oil-rich Venezuela, since oil is priced in dollars. The greenback is down sharply against the yen this year and more sharply against the euro.
The recent crack in emerging markets has been described in part as a flight to quality, and as of today, quality still includes Treasury bonds because the greenback is the world's reserve currency. But China recently began to de-link its currency from the greenback, and China is among the largest foreign owners of Treasury bonds.
These are tell-tales that the world is losing its reverence for the dollar. So is the surprising strength in the gold price, which a growing number of observers predict will never again sell for less than $600 an ounce. A recent Barron's had this arresting headline: "Yes, $8,000 an ounce."
If investors flee the dollar, that means they will also flee U.S. bonds -- and stocks.
Readers often ask me why I don't own a fund I'm writing about, and I don't own Prudent Bear, so I'll tell you why: I have a blind, stubborn prejudice against shorting, and against gold.
But both biases are being eroded by this 800-pound gorilla, the current-accounts deficit. Absurdly, the White House doesn't even have to address the issue because reporters (and Congress members) don't take economics in college and therefore don't know what it is, let alone why it's important.
It is important, and very shortly I'll be adding Prudent Bear to my personal portfolio, in the amount of 5% to 10% of total assets. As with my model portfolio of exchange traded funds, I am taking other defensive steps, such as raising cash levels.
My colleague Jon Markman is forecasting a market decline of as much as 25% within a few months. Markman dismisses the idea of a secular-bear market in stocks that could last at least another 10 years; his is a short-term call. I (and Tice) do believe in that long-abiding bad market. I plan to own Prudent Bear for a long time.
At the time of publication Timothy Middleton didn't own any securities mentioned in this article. Middleton writes about investing for a variety of publications, and is a radio commentator for WCBS in New York. A former reporter for the Dow Jones News Service and editor at Crain's New York Business, he works from home in Short Hills, N.J.
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