Learning How and When to Short the Market

By: Robert Gordon | Tue, Apr 20, 2004
Print Email

A Primer for Mutual Fund Investors

In a diversified bear market portfolio holding at least 6 funds, at least one should be short stocks and perhaps another should be short bonds. Readers who disagree are invited to read my words and reconsider their position.

I am not aware that any of the big line, no load families have started or even thought of starting a fund that could increase in value as the general market goes down to much lower levels. This is perfectly consistent with their lack of recognition that, in most centuries, the stock market goes down about half the time as it did in the 20th century.

There are also quite a few funds with the option to go either long or short as the manager determines and other similar funds, called market neutral funds, that can be both long and short. From the data I have seen, their performance has been quite spotty. In contrast, I am quite happy with my short funds.

We will concentrate our attention on discussing ways to use five quite different types of short funds:

A fund that is 100% reverse the S&P500 Index
A fund that is 100% reverse the Nasdaq 100 Index
A fund that is 100% reverse the 30 Yr. Treasury bond
A fund that is 200% reverse the Nasdaq 100 Index
A fund that is fully managed by its manager

The Current Bear Market Climate

Investors of all ages and experience levels are now in uncharted water as the market starts its second big wave down. This bear market has already exceeded the length of the 1929 bear market which now appears very short compared to Japan's current 14 year decline. A small number of stock funds still show a positive record over the past 4 years along with bond funds which, until recently, were benefiting from very low interest rates. It will become increasingly difficult for any of the conventional long stock funds to show consistent gains in the expected future environment.

Although Wall Street and the general public are still bullish, their attitude will certainly change as the decline now underway picks up speed. All investors, desiring to continue growth of their assets, should think seriously of starting at least a very small trial venture on the short side of the market. I made that decision about 5 years ago and now consider that long and short funds are equally important in my current investing.

It is almost impossible to forecast the future returns on almost any type of mutual fund that is long stocks or bonds. But, as we show below, several types of short funds have delivered positive returns over the past 4 years. We anticipate that those returns will continue.

The Basics of Short Mutual Funds

Regardless of the composition of their portfolio, to my knowledge all short funds operate in a similar manner except for their choice of short positions. Their basic holding is in high quality, short-term debt instruments against which they borrow and purchase short positions in stocks or market indices. When I buy a short position in a stock, which I first did in the Cuban missile crisis of 1962, the order to the broker is identical to a long order to buy, but reversed. When buying shares of a short fund like Prudent Bear, you are buying a long position in a fund that owns short positions. My understanding is that my loss in a short fund is limited to the dollars I paid for it. And, since it is readily saleable when the market is open, I do not ever expect to lose all or any large part of my money. I treat ownership of a short fund exactly the same as any regular fund, the only difference being its price goes up when the market goes down.

Although there are several fund families that offer reverse index funds, my only experience is with the Rydex family. The minimum account at Rydex is $25,000, but many on-line brokers charge $2,500 or less to purchase one of the Rydex funds.

To my knowledge there are just two managed short funds, the Prudent Bear Fund, the oldest and the Leuthold Grizzly Short fund. The Leuthold fund is always short and has suffered in the recent bear marker rally, while Prudent Bear is flexible in its holdings and has had a large gold holding at times. David Tice of Prudent Bear has had a business for some years recommending short positions to hedge funds and other large investors, so he is an old hand at picking stocks to short.

Market Performance of Short Funds

Annualized Change Between Dates
Short Fund 4/12/00 to 2002 High 4/12/00 to 4/15/04
Prudent Bear 45.1% 16.6%
Reverse Nasdaq Index 49.8% 6.1%
Leuthold Grizzly 28.0% 0.0%
Reverse S&P500 Index 22.2% 5.2%
Reverse 30-Year Bond N/A -6.1%
200% Reverse Nasdaq 67.4% -12.1%

Please note that only 3 of the 6 short funds produced gains over the full bear market to date. With the exception of the reverse bond fund, all funds held very good gains at the time of the October 2002 low in the market, as shown in the left column above. There are at least two lessons from this data. A fully managed fund is perhaps the only one that can be bought and held for the duration of the bear market. However a much better result would come from portfolio rebalancing at the market low and high of the short funds. The reverse 30-year bond fund has been gaining for the past months and presumably will do well until interest rates stabilize at a much higher level.

Since many experts and I expect severe declines in virtually all stocks for years in the future, we have very good expectations for well managed short funds. There will continue to be bear market rallies where the short funds will decline in price. However with good timing in rebalancing the portfolio at these low prices, future profits will be made.

We definitely do not recommend that anyone other than an experienced investor get involved with the leveraged short funds. They can be wonderful profit makers but they are very volatile and demand skilled management.

Making Your First Short Fund Purchase

In theory, it should be possible for many readers to make a small first purchase of a fully managed short fund, but I do not expect that to happen. I have no words to change any natural objections to going short that some readers may have. But for those who are interested in adding it to a conservative portfolio, it may become a practice you will follow for the rest of your life. Please remember that Elliot Wave experts expect this bear market will last for a very long time with a number of very large up and down cycles that will confuse nearly every so-called market expert.

Let's step back a minute and discuss the Elliott Wave action in a typical market. First of all, please know that every single market price move, either up and down, both small and large is creating waves that follow the set of rules laid down by Elliott and his followers. If you have the capability to record these waves, even those measured in seconds, you will see the same kind of impulse and corrective waves measured in days, weeks, and centuries. Every market in the world for any stock, bond or commodity follows the same laws. All of the European markets are right now in the same status as ours, which is why we know we are entering a world crash, not just one in the U.S.

There are short-term traders in various markets that try to take advantage of short market cycles and, although we do not use them, we long ago learned to pay no attention to them. We are interested in the big cycles that cover months. They produce changes in our portfolios that we correct by periodic rebalancing. And if we have some other volatile asset classes, we hope to use their volatility to gain additional profits from rebalancing.

We are entering a period in the market where even our favorite stable funds may decline for a while. We have previously recommended adding other funds which can correct any weakness. PRPFX is now falling in price because of its 25% in gold and silver. It also holds 30% common stocks which may well decline. If any reader holds only PRPFX, the logical thing to do right now is to add a short position to balance the assets that are falling in price. You could start with 15% short positions and then add small increments until the price is stabilized. This is a perfectly safe and sound thing to do since several short funds have demonstrated their ability to provide profits in the past 4 years over both up and down markets.

A small position in a short bond fund would be advantageous for most all portfolios, at least in the near future since interest rates are now rising and almost certainly will continue to increase. At the moment, the dollar is rising against the Euro so the foreign government bonds are dropping a bit. This situation could be alleviated with a small addition of several of the short funds.

Another Way to Look at a Short Fund

We have been writing for a long time about stable and volatile funds. It is a perfectly valid idea to think about short funds as being just another class of volatile funds. Their price may or may not go up or down with other volatile funds but they all "march to different drummers". Right now, it seems that gold funds are going down. If you do not wish to sell and repurchase them, you can buy a sufficient quantity of short funds and protect your capital. The availability of short funds for small investors will be of tremendous benefit in this great bear market. So, maybe one way to convince yourself to take advantage of short funds is to consider them as just a very useful and profitable volatile fund. In reality, that is exactly what they are.

Making a Pseudo Stable Fund

I have previously mentioned finding several funds in Morningstar's "Conservative Allocation" category which own 60-70% bonds and the balance stocks which have performed very well so far. In the new bear market drop, with interest rates also rising, I expect their performance to drop and even go negative. It is a fairly simple and risk free task to bring this performance to a more desirable level by adding small increments of a short fund.

Over the past 4 bear market years, these two fine funds have shown average annualized gains of 10.2%, a very fine record for stable funds. In the past 6 weeks, with interest rates moving higher and bond prices lower, the average of these two funds dropped 21% per year on an annualized basis. This may be a temporary effect which will moderate soon, but I do not like to take losses that are preventable. I would probably add 10 to 15% of a fully managed short fund as soon as the drop in performance was noticed. I would then watch the combined performance closely and increase the short position if the performance was not positive. An alternative would be to acquire a position in the short bond fund mentioned earlier.

This example for the use of a short fund is both simple to understand, perform and monitor. It may be necessary to make this correction on several other stable funds. Early on in my investing career, I learned to abhor losses and to sell or modify my positions to stop them. It is most important for my readers to adopt the same "don't lose" attitude in what may be a very long and harsh bear market. The short fund option has only been available for about 5 years but it can be a tremendous aid. I hope that many readers will open a modest short position and see its benefits. You have to do it to learn how simple and effective it can be. It will not be enough to read about it here and think about it. To obtain the advantages, you have to act.

In past months we have published the details of a variety of portfolios which included one or more short positions. Any reader who has started such a portfolio should check the results in the early stages of the renewed bear market to see if the allocation to the short fund is adequate or needs to be increased. Please allow enough time to make sure that a change is really needed. We should not be concerned with every short price change. Checking about once a quarter may be about right.

Other Reasons for Owning Short Funds

The vast group of public investors do not know that short funds exist and are one of the best things to own in a very long bear market. Only a small minority of investors will ever buy them even though they are one of the best asset classes to own in the years ahead. For instance a young investor, just starting out, could open a tax free account in Prudent bear and watch it grow over the years. This accumulation plan could be a real winner. Very unconventional, yes, but it is a sure growth fund so long as the bear market lasts.

Owners of gold in any form might consider buying a quantity of short funds to soften the tremendous volatility of gold. Despite the fact that Robert Prechter claims gold has made a major top, un-believed by the gold "bugs," investors could protect their gold position with an equivalent short position and sleep well every night.

New Investors Should Not Panic

Any new or old investor who worries about every daily price change in their portfolio may need to consider putting their assets in a U.S. Treasury money market fund. There will be days ahead when nearly every stock on the exchange will go down and dropping prices on most mutual funds as well. It is essential to give a good fund manager time to adjust to new market conditions. Here is what happened to the two Hussman funds in the past thirty days. The growth fund gained 1.65% and the income fund lost 2.12% due to a jump in interest rates. There is always less volatility in any portfolio that holds 5 or 6 funds. Ten funds will be even more stable. If you are holding only 2 or 3 funds, you will sleep better if you add a few more very stable funds, or possibly one of the special volatile funds described above.

In a down market, holding 20 to 30% short positions is conducive to sleep at night. Since we expect stocks to go down and interest rates to rise, we suggest holding short funds for both stocks and bonds. Over a six month time period, it will be possible for even new investors to determine an appropriate level for their short positions. They will help greatly in the months and years ahead. So start slowly and add as you learn. Looking back years from now you will consider it to have been a wonderful decision.

Please remember that this bear market will have huge up and down price swings. In my opinion, only the Elliott Wave picture will give investors the correct guidance information. Our Wall Street "experts" will be totally confused and may vanish from the TV screen some years from now. It will not be possible to determine the success or failure of any portfolio over a short time period. It may be desirable or necessary to make some portfolio changes but be sure to do them on the basis of the best information available at the time.

Predicting the Future

The next few years of your life will be like nothing before. The general public will have no idea of what to do as the 3 huge bubbles in stocks, credit and real estate come crashing down. Other major nations have similar bubbles, so it will certainly be a Global Crash that will connect up to the 14 year old depression in Japan. combining to produce perhaps the very first Global Depression ever.

My experience in the Great Depression of the 1930s provides me with no way to predict this one, but I cannot see any possibility of it being other than a very great disaster. I have tried in the past 2 1/2 years to prepare my readers for what lies ahead. If you are fortunate to keep your family together and your financial assets in reasonable shape, your chance of survival will be good. My health is failing and I do not know how long I can continue to write but I will do it so long as I can. I enjoy reading and answering your e-mails so keep them coming.


Author: Robert Gordon

Robert B. Gordon, Sc. D.
Sun City West, Arizona

© 2004 Robert B. Gordon, Sc. D.

All Images, XHTML Renderings, and Source Code Copyright © Safehaven.com