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How Do You Pick an Investment to Short?

The popular movie, The Big Short, dramatized how hedge fund manager Michael Burry made a profit of $2.69 billion by anticipating the collapse of the US housing market in 2007. Burry created a credit default swap market when he realized that the vast number of high risk subprime loans made the housing market unstable. There is a lot of detail in the movie but the point which interests us here is how do you pick an investment to short? This thought came to mind as we consider and re-consider the aging bull market, the risk of a trade war with China, and the ever-mounting US debt burden.

Predicting Investment Success or Failure

Some investments require unique knowledge to succeed in. And for others you simply need to understand intrinsic value and invest for the long term. Patience is a virtue in this case. Picking an investment to short requires that you recognize when that investment no longer is likely to grow with the economy and the rest of the market or when there are unique factors that will lead to its demise. We wrote about what are the most profitable investments.

The general consensus is that you need to stay in an investment at least five years and probably ten to see the benefits of long term investing. The S&P 500 peaked at 1509 in November of 2007 and bottomed out at 683 in March of 2009. Ideally you would have purchased shares in an ETF that tracks the S&P 500 and done so in March of 2009. But a long term investor would have purchased in 2007 as well. Today the S&P 500 is at 2600 after peaking above 2800 in January of this year. Successful market timing can help but it is difficult to carry off time and time again. The point is that if you had bought the S&P 500 at its high point before the crash and held on you would be up around 80% today. If you had added to your portfolio as the market went down in 2007 and 2008 you would have done even better.

In that article we noted that Kodak which was a great stock for decades became a loser when digital photos came into being and Kodak’s business plan no longer worked. A way to pick an investment to short is to pick the next Kodak. However, the demise of Kodak worked out over a couple of decades and was affected by the company dipping into its cash reserves to buy back stock and prop up the price.

Best Time to Short an Investment

The couple of years preceding the housing market and stock market crashes a decade ago were exuberant. People bought stocks as well as second and third homes with the belief that prices would only go up. Warren Buffett famously said that the best time to buy is when everyone is getting out of the market and the best time to sell is when everyone is getting in. The key for picking investments to short is to calculate intrinsic value. The key to timing the market and making the most profit when shorting an investment is technical analysis. This is the statistically based analysis of market price patterns. Technical traders say that the past predicts the future and that when you can recognize an emerging price pattern you can trade accordingly to make a profit as the pattern plays out. Using statistical analysis to predict a peak in the value of an investment helps you choose when to short an investment and when to buy back at a lower price as the pattern plays out. As a bull market ages it tends to become volatile. That volatility can be an asset when you pick an investment to short.





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