2014: The Year of the Short Seller?

Market Returning to Normal Without a CorrectionThe more this stock market rises, the more we are seeing the bears emerging from the woods, talking about how a nasty stock market correction is on the horizon.

In my opinion, based on the last few years, we could see the stock market correct about five percent or so. A sell-off could also be much more if triggered by a major event, such as really bad earnings or an increase in the rate of tapering by the Federal Reserve.

But while I do feel the stock market is vulnerable, I also believe stocks will advance higher this year, as long as the economy and jobs market continue to improve. (Read “Could This Bull Market Last a Decade—Or Longer?”)

Of course, there are also the bears out there who are becoming increasingly agitated with every passing day and every new record set by the S&P 500 and Dow Jones Industrial Average.

It’s not that these short sellers are wrong. In fact, many of the companies these bearish investors decide to short are indeed bad companies that don’t deserve to partake in the overall bullish bias in the stock market. The problem faced by these short sellers, which I have also faced in my trading, is their inability to fight the upside momentum that has encased this bullish stock market.

Look at the horrible downward move by the ProShares Short S&P500 (NYSEArca/SH) exchange-traded fund (ETF) in the chart below.

ProShares Short S&P 500 Fund NYSE Chart

Chart courtesy of www.StockCharts.com

Just when you think the stock market should be headed downward, nothing happens or we see a rally following a small down day. That’s the way it was in 2013.

I was listening to an interview by Brad Lamensdorf, co-manager of AdvisorShares Ranger Equity Bear ETF (NYSEArca/HDGE), and what I heard was much of the same that I’ve been saying about the stock market for some time. Regardless of some poor underlying metrics, stocks have headed higher. (Source: Lewitinn, L., “Here are four reasons to be short the market: Portfolio manager,” Talking Numbers, Yahoo! Finance web site, January 21, 2014.)

You can kind of hear the frustration in Lamensdorf’s voice as he discusses the reasons why he is bearish on the stock market and expects a nasty correction this year. Essentially, Lamensdorf is suggesting a stock market correction is on the horizon due to four negative metrics—bullish sentiment polls, aggressive insider selling, high margin debt, and low credit spreads.

Now, I agree these are valid reasons why the stock market should be set for a major adjustment, but the same variables were present in 2013. If you shorted last year, the result would’ve been horrible, as you would’ve not only missed out on the gains, but you would’ve also suffered major losses when you had to scramble to short cover.

So while I do feel a correction is due, I don’t believe you should be shorting due to the high risk of losses. Rather, I would suggest playing a downside correction via more manageable risk-oriented put options on ETFs, stocks, key stock indices, or sectors.