Today officially marks the seventh year of the current bull market. We’ve had our rough patches, sure, but anyone who stuck it out should be smiling. (In fact, that’s a theme Matthew Carr will be touching on in tomorrow’s issue.)

Blue chips are up 160% from their low in March 2009. Of course, the question now is… how much longer can the good times last?

[ad#Google Adsense 336×280-IA]A lot of market pundits argue that the end is nigh.

And those comments – egged on by several months of volatility – have started a dangerous trend.

Consider Alex’s remarks below a “PSA” for anyone desperate to score big gains in a down market.

The market has performed poorly this year.

Many stocks are down.

That has a lot of investors thinking about betting against the market by selling short.

They might think again.

I have shorted stocks on many occasions and ran a short-selling advisory service, The Short Alert, in the bear market of 2000 to 2002. But I can tell you from more than 30 years of hard-won experience that shorting is far tougher than buying stocks… and the average investor should give it a miss.

Here’s why.

Selling short means betting that a particular stock – or sector of the market or the entire market – will fall.

You already know that if you buy a stock (or ETF) at $20 and you sell it at $25, you’ll make $5 a share. A short sale is just the opposite. If you sell a stock short (meaning you sell it without first owning it) at $20 and buy it back (or “buy to cover”) at $15, you’ll also make $5 a share.

It’s that straightforward.

Those who advocate this strategy generally emphasize that a) stocks go down a lot faster than they go up and b) when a leading index undergoes a correction or worse, three out of every four stocks in that market decline.

All true. But it’s not the whole story. Short selling is an art, a difficult one that requires excellent research, quick decision-making and nerves of steel.

If you buy a stock, for example, the most you could lose is 100%. Granted, your stock would have to go all the way to zero for that to happen, but then many have done just that in the past.

However, there is no limit to how high a stock may go. So you could lose a lot more than 100% on a short sale. For example, if you short a stock at $20, you will be down 100% (or $20 a share) if it rises to $40. But it may go higher still. Much higher. If it goes to $60, for example, you’re down 200%. If it goes to $80, you’re down 300%.

That’s why the SEC requires that all short sales take place in a margin account.

Short selling might seem easy if you just stuck to struggling companies with high debt, declining sales and negative earnings. But that’s a deceiving notion. The market is pretty efficient. Bad news is discounted in the share prices of lousy companies the same way good news is discounted in great ones.

The shares of fast-growing firms tend to be expensive relative to sales, earnings and book value. The shares of troubled companies tend to be cheap relative to sales, earnings and book value.

In the words of Milton Friedman, “There is no free lunch.”

You can, of course, use buy stops to limit your losses on short positions, the same way you use sell stops on long ones.

But stocks in a strong downtrend can be volatile. On their way down, they often temporarily spike sharply higher. That, in turn, can trigger your buy stop, knocking you out with a loss.

Ironically, the spikes are often caused by other short sellers rushing to cover every time the market rallies or there is a bit of good news on the company. (Your fellow travelers, in this case, are your worst enemy.)

However, the biggest drawback to short selling is the market itself. It goes up most of the time. History reveals that the average bull market lasts 97 months. The average bear market lasts just 18 months.

That means if you short stocks on a regular basis, you will be going against the primary trend – swimming against the tide – 84% of the time.

I don’t like those odds. And you shouldn’t either.

Most investors would be better off leaving short selling to the investment pros.

And the investment pros? Judging by the number of short-only hedge funds that have closed shop, most of them would be better off doing something else too.

Good investing,

Alex

[ad#IPM-article]

Source: Investment U