5 Commandments for Selling Short
The Most Heavily Traded Stock in the U.S.
Bank of America Corporation (BAC)
---Last week, one of my readers wrote:
“I've done pretty well with Cabot Stock of the Month, but its weakness is bear markets. Instead of looking for one of the few stocks going up, we should be finding one of the many going down.”
Dave S. Ansonia, Connecticut
“Thanks for the note. I may write more about selling short in a future issue of Cabot Wealth Advisory. For now, the main points to remember are that we are still in a bull market, as determined by the Cabot Timing Indicators. And when a bear does come, the best shorts are 1) declining stocks that were most-loved, and 2) declining stocks of businesses that are failing.”
To which he replied:
“Bull market??? Of the eight stocks in your portfolio, 7 of 8 were down today. I think you better take the indicators into the shop. Or if we are in a bull market, you have to be a lot better at stock picking. I mean, even just taking wild guesses, you should end up with more than 1 out of 8 going up on any given day in a bull, (or even a neutral) market. I could understand them all going down if they were all in the same sector, but they're not.”
Knowing that Dave is not the only reader with these thoughts, I now bring the larger exploration of the short-selling question to all of you, in the form of my personal five rules for selling short.
1. Thou shalt sell short only in bear markets.
I mentioned this to Dave, of course, and he countered by noting that seven of my eight stocks were down that day—which was true but of little relevance. Just as one warm day doesn’t mean it’s spring—one big down day doesn’t mean the bull market is over. Yes, it might be, but we’ll only know for sure after our trend-following tools tell us so. (For the record, on Friday morning all of my Stock of the Month recommendations were up.)
The other reason for shorting only in confirmed bear markets—and most people forget this—is that the real long-term trend of the market has been up for centuries, and will continue to be up as long as investors perceive that the U.S. economy is growing. Usually, this long upward trend helps investors, which is why holding index funds for decades is one decent investing strategy.
If you want to invest contrary to this upward trend, you better be darn sure there’s a real bear market in force to help you.
2. Thou shalt sell short only stocks that are trending down.
This rule, like the first, ensures that the odds are on your side when you short. Trends continue, so you want to be sure that the stock you’re shorting is already in a downtrend. Sure, it’s nice to dream about shorting a ridiculously overvalued stock at the top and riding it down, but picking tops (and bottoms) is a fool’s game. Put the odds in your favor and only sell stocks short that are in confirmed downtrends.
3. Thou shalt sell short only when public opinion of the company behind the stock has a long way to fall.
Stocks decline because investors lower their expectations about the stock’s future. For little-known stocks (like Zulily, for example, which I wrote about here last week—and which found support at its 50-day moving average last week), expectations can’t fall much because there aren’t many expectations. If anything, expectations are likely to rise as people discover the company and the stock.
It’s far better to short stocks that might be over-owned, and stocks that are or were well loved, and which are thus ripe for lowered expectations. Apple (AAPL) was a classic example of that; when everyone loved the stock, it had nowhere to go but down—and once the downtrend got rolling, it didn’t stop until the stock had lost more than 40% of its value, yes, even though it was “cheap” by most measures.
Not all good shorts need to be as high profile as AAPL was, but they do need to have the potential for expectations to fall substantially.
4. Thou shalt at all times beware of the mathematical realities of short selling.
When you buy a stock, hoping it will go up, the most you can lose is what you invested—while there’s no limit to what you can win. That’s a pretty good trade-off.
However, when you sell a stock short, the very best result—if the stock falls to zero—is that you double your money. But if the stock goes up instead, there’s no limit to the amount you can lose! Yes, you can buy the stock back any day to cut your loss short, but if you’re pig-headed and you cover your loss by throwing good money after bad, there’s no limit to how much you can lose! That’s not a great trade-off.
5. Thou shalt not get greedy.
When you put it all together, it becomes clear that selling short is a high-risk proposition that can only work at certain times, and even then, it’s unlikely to work for long. So when you find yourself with a profit from selling short, take some off the table. Let some ride, if you like, but remember that eventually, the market’s long-term upward trend will return, and it will be hard to swim against that tide.
Note: if you do want to profit from the market’s downside action as well as the up, I recommend you consider Cabot Options Trader, where analyst Jacob Mintz uses a controlled-risk strategy to guide increasing numbers of satisfied readers to consistent profits, while keeping losses small.
In fact, Jacob has done such a fine job in his first year at the helm of Cabot Options Trader that we’ve just launched Cabot Options Trader Pro, which specializes in more sophisticated options strategies like spreads, straddles and iron condors.
Turning to stocks, I’m going to do something different today. I’m going to write about a very popular and heavily traded stock. In fact, trading volume was the only criteria used to select it; it was the most heavily traded stock on Friday.
Bank of America Corporation (BAC)
We all know Bank of America, and we all know basically what it does. It lends money, with the belief that more will return. Usually, it does.
Furthermore, Bank of America is really big, with $102 billion in revenues last year and a market capitalization of $180 billion.
Also, the company and the stock are extraordinarily well followed. Every day, you can read new well-informed opinions on both the company and the stock.
Which means, to me, that there’s no value to be gained by immersing yourself in the minutia of the bank’s fundamentals. When everyone knows something, knowing it gives you no advantage.
The way you get an advantage, of course, is by studying the chart. So let’s take a look, starting with the very long-term chart.
My chart starts in 1971, and the first major feature of the chart is a crash in 1974, which followed the 1973 Oil Crisis, the devaluation of the dollar and the 1973-1974 Bear Market that took the Dow down 45%.
BAC lost about 80%.
From 1974 to 2008, BAC’s main trend was up, though there was a very steep correction in 1991 (down 70%) and a very long and deep correction from 1999 through 2001 (down 55%).
But the 2008-2009 Bear Market—you remember it well—was a doozy, sending BAC down some 95%, as Lehman Brothers went under and fears of other bank failures depressed the entire sector. It didn’t help that Bank of America had acquired Countrywide Financial months before the housing sector topped out.
The rebound from that low was followed by the big correction of 2011, as the company laid off roughly 36,000 employees. That took the stock down 75%.
It recovered, of course, and since that 2011 low, BAC is up 240%—but still far below its highs of 2008.
So what comes next?
There are several ways to look at it, depending on your perspective.
The long-term perspective says that BAC’s Relative Performance (RP) line peaked way back in 1973. Overall, it’s lagged the market since.
The intermediate-term picture is actually worse; it shows us that BAC has been a serious underperformer since 2003, even considering the recent rebound.
Lastly, the short-term picture shows BAC slightly outperforming the market, as people grow increasingly comfortable investing with the bank again. This year, it’s up about 10%, and all things considered, I believe this trend will continue.
So should you own it?
Well, it yields only 1.2%, so you wouldn’t own it for the dividends.
And if you’re after capital appreciation, you can certainly do better in less popular stocks. One of BAC’s main attractions to institutions is its exceptional liquidity, and you don’t need that.
Also, none of our Cabot advisories recommends the stock. It fits none of our proven investing systems.
Nevertheless, if you’re looking for a stock where the odds favor higher prices over time, BAC gets my approval. The major trends that govern its business are positive and they will probably run loonger than most people expect.
Just don’t be left holding the bag in the next big downturn.
In fact, if you really want a safe investment for your retirement, I recommend that you take a look instead at Cabot Dividend Investor, which can help you build a diversified portfolio of low-risk holdings that will bring you steady income, far more than you’ll get from Bank of America. And with a diversified portfolio, you won’t get killed like BAC shareholders in the next financial crisis.
Yours in pursuit of wisdom and wealth,
Chief Analyst, Cabot Stock of the Month
Publisher, Cabot Wealth Advisory