Is Short Selling Worth It?

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With the markets having retreated into bear territory, I have received many reader questions regarding shorting the market. Nowadays, you have many more choices than compared to the last bear market of 2000-2002.

With the proliferation of ETFs, you are no longer limited to a few bear market mutual funds, you can now buy with great ease inverse ETFs like SH or SDS, that perform opposite to the S&P; 500 or, in the case of SDS, 200% of that value. Of course, if you go that route, be sure to use my recommended sell stop discipline, because bear market rallies are always lurking around the corner.

However, if you take a longer term view, say 15 years, how much will short selling really contribute to your bottom line?

To get some kind of answer, I went back to the previously reviewed book “Trend Following” by Michael Covel.

Michael has researched the investment results of many of the well known CTAs (Commodity Trading Advisors) and detailed some his findings of various trend following systems in his excellent book (p. 270). As you may know, CTAs are probably the most aggressive investors when a short selling opportunity presents itself.

One example, which I found very typical covers a period of 15 years (1990 – 2005) and shows the following annualized gains:

Long + Short: +19.59% (515 trades)
Long Only: +18.86% (368 trades)
Short Only: 5.64% (147 trades)

As you can see, long-term, the short positions have not contributed much to the overall return.

Before you get all excited about this approach, keep in mind that these are leveraged investments and the downside as always is the Draw Down, meaning how much the portfolios have fluctuated:

Long + Short: -46.96%
Long Only: -75.77%
Short Only: -60.36%

For most investors, this is not an easy pill to swallow to see portfolios drop by these numbers. I know, because many people are having difficulties with the fact that the current bear market has shaved off a very modest 10% off the value off their holdings.

This is just one example of how much short selling contributes to the bottom line. If you happen to be a conservative investor you can see that, based on the above numbers, you do not need to be actively shorting the market just because your friends are. If staying on the sidelines is more fitting to your risk profile then by all means do so.

These numbers simply point out that, long-term, short selling for the individual investor may not have the impact on returns as you thought it might.

No Load Fund/ETF Tracker updated through 7/10/2008

Ulli Uncategorized Contact

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Despite various rally attempts, the bulls succumbed to the bears again this week.

Our Trend Tracking Index (TTI) for domestic funds/ETFs remains decisively below its trend line (red) by -2.95% thereby confirming the current bear market trend.



The international index dropped as well and now remains -12.22% below its own trend line, keeping us on the sidelines.



For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

A Slippery Slope

Ulli Uncategorized Contact

After a rebound rally on Tuesday, reality set back in on Wednesday and sent the major averages sharply down with the Dow losing some 237 points.

Financial stocks tanked again with Fannie Mae and Freddie Mac leading the charge by dropping an astonishing 13% and 24% respectively and reaching price levels of the early 90s. The major indexes have now all come off their October 2007 highs by more than 20% and have entered bear market territory according to the text book definition.

Our Trend Tracking Indexes (TTIs) followed suit and to no surprise, more ground was lost confirming bearish tendencies. Here’s how the TTI’s ended up as of Wednesday’s close:

Domestic TTI: -2.83%
International TTI: -12.12%

None of our positions have changed with the bulk of our portfolios being in cash, a small percentage in Swiss Francs and Gold and a limited exposure to some hedged mutual fund positions as previously discussed.

Explaining The Obvious

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If the entire Subprime/credit crisis disaster would not have had such dire consequences, the following story could be considered a joke as the “Fed plans new rules to protect future homebuyers.” Here is one of the highlights of these proposed revolutionary changes:

Under the proposal unveiled last December, the rules would restrict lenders from penalizing risky borrowers who pay loans off early, require lenders to make sure these borrowers set aside money to pay for taxes and insurance and bar lenders from making loans without proof of a borrower’s income. It also would prohibit lenders from engaging in a pattern or practice of lending without considering a borrower’s ability to repay a home loan from sources other than the home’s value.

[my emphasis]

Wow; these are really earthshaking rules. Somebody will actually have to prove that he has income before buying a home? Ridiculous! And to top it off, the borrower actually has to show that he can make the payments? How low can you go?

We are living in the supposedly most developed and sophisticated nation in the world, and we are now coming up with rules and regulations that have been basic knowledge around the world for centuries. It’s a sad state of affairs that we now have come to a point where we have to state the obvious, that you simply have to be credit worthy to get any kind of loan.

How this fact has been “overlooked” by those underwriters responsible for its implementation during the formation of the housing bubble will always be a mystery to me. On the other hand, this mortgage fraud was one of the greatest pyramid schemes in history and, in my view, a once in a lifetime event. The consequence will be far reaching for years to come, and I sure hope that some justice will be served as it usually is when guilty parties to a Ponzi scheme are caught.

Cliff Diving

Ulli Uncategorized Contact

If you look at yesterday’s chart of the Dow (thanks to MarketWatch), the word cliff diving comes to mind. Good thing that there was some type of recovery, or it could have been a real ugly day.

When all was said and done, the widely followed S&P; 500 closed at its lowest point since July 2006. It is obvious that confusion reigns, with heavy selling focused on the financials. There seems to be some panic in that sector and one analyst was quotes as saying that “the CEOs and financial officers in that industry aren’t lying when insisting that the worst is over, but they don’t understand the depths of the problem.”

I agree with that and an article from a German newspaper seems to support a similar view.

Translated, the article says that, according to a study, the crisis in the financial community is to be far worse that expected. Bridgewater Associates, the second largest hedge fund in the world and advisor to many top banks, estimates losses of $1,600 billion vs. the $400 billion which so far have been realized.

If that comes to pass, it will spell trouble for many financial institutions. However, since we don’t control that outcome, we remain in trend following mode. As of yesterday, here’s how our Trend Tracking Indexes (TTIs) stand:

Domestic TTI: -3.10%
International TTI: -11.68%

These numbers confirm that we are in a bear market, which means that we have most of our assets safely in money market (U.S. Treasury) on the sidelines as well as some small holdings in a fully hedged position.

Accurate Predictions

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In the past, I have poked some fun at those making outlandish predictions, since in most cases the results are more or less based on nothing but luck. However, sometimes an individual can accurately analyze present economic conditions, especially if they are totally out of whack with reality, and come to logical conclusions as to what the likely outcome will be.

This was the case with Peter Schiff, the owner of an investment company, who made some dire real estate predictions back in Dec. 2006. He actually walked the talk by selling his home in Orange County, California, relocating to another area and becoming a renter.

It appears that Peter was right on with his at the time heavily criticized and laughed at viewpoints.

Calculated Risk featured 2 video clips with Peter. One shows him on CNBC where he reiterates his opinion, which is spot on. It’s worth listening to.

The other video clip features him back in 2006 in a discussion with several so called experts making housing predictions. It’s pretty funny when you see some of these jokers making the case for a continued housing boom vs. Peter’s straight forward analysis.