Why Timing Matters For Short Selling
If only I'd waited a couple of years
Betting against overvalued stocks can be insanely profitable — if you use put options and get the timing right. But those are big “ifs”. Here’s a cautionary tale.
Back in May of 2023, when this newsletter was new and its recommended Portfolios needed fleshing out, I named the homebuilder stocks as excellent short candidates. Home prices were too high, mortgage interest rates were rising, and the overall stock market looked ready to hit a wall. So housing was a dead business walking.
I provided the following list of homebuilder stocks, along with a sector ETF, and said that betting against some or all of them with long-dated put options might pay off in the ensuing couple of years.
Good Idea, Unfortunate Timing
Sadly, the housing market — and markets in general — were a little more resilient than they seemed. New home sales held up, homebuilder profits remained robust, and their stocks marched higher for the next 18 months. Below is Lennar, a big homebuilder with a representative stock from the May 10, 2023 recommendation date (at $114 per share) until I capitulated and removed the short recommendation at around $170.
Then — almost immediately — the short thesis started to work. The incentives homebuilders had to offer to induce people to buy their ridiculously unaffordable houses started eating into profits, and their stocks started falling. Lennar is down by about 40 points since I threw in the towel.
The Lesson?
Shorting, especially with put options that eventually expire worthless if not sold, requires the short seller to be both right and timely. This is vastly harder than it looks.
But…it’s still worth doing. Put options have two functions: First, they provide a cheap way to bet on an expected outcome, and, depending on the option strike price’s relation to the underlying shares, can return big multiples of the purchase price when those shares fall. Second, they’re relatively cheap insurance against your long positions going down instead of up. Put those two benefits together, and a case can be made for always allocating 5%-or-10% of one’s capital to long-dated puts on either broad market averages or objectively overvalued stocks.
I remember when JR talked about shorting the home builders and thought at the time that was a pretty good bet, especially given the time frame.
But the crazy thing, in my mind, is that even though we’re two years closer to the “inevitable” market correction things seem muddier than ever to me.
About a third of the country are hopeful and happy now (and probably have most of the investment funds) and that kind of sentiment could extend things for even longer.
I like the idea of shorting about 5-10%, but personally I have more confidence that gold and the miners have a much better than even chance of going up significantly going forward.
Not only do they capture the bullish sentiment that seems to be in play, but I think gold in particular will continue to “rise” (in dollar terms) for several reasons, and the miners as a group are one of the only stock classes that isn’t over- (or even fairly) valued, and that increases the likelihood of an outsized upside both near and long term. Similarly for commodities and resource stocks, but less so.
Financially speaking, the miners are a leverage play on the gold price, and I think it’s heading higher for several macro and structural reasons.
For one thing, there are many reasons why the US dollar needs to weaken relative to other currencies, and Trump is trying to do that. The trade deficit needs to go down for the tariffs to work as intended, and a weaker dollar will make US exports more affordable. A weaker dollar would be reflected by a higher gold price (but also price inflation.)
Another thing I think Trump will get around to is looking at the “balance sheet” of the US and seeing that it has many assets that aren’t priced “mark-to-market.” Things like government owned land and - importantly - gold. Doing that would reduce net US liabilities (aka the national debt) by many trillions, at least on paper.
I think it’s also possible that Trump might re-establish a gold standard for the dollar as a way to deal with the de-dollarization efforts globally. It’s highly debatable what the gold price would have to be to back the dollar but even the most simplistic estimates would put it well over $10,000 per ounce. Just imagine if that is “leaked”: Gold would go up even if backing never occurs. In fact, that could be a great (and most sound) way to determine the “true” gold price. The market would decide, just like interest rates should be established.
The End Is Nigh:
The phrase 'The End is Nigh' derives from a man who could often be seen walking up and down London's Oxford Street wearing a sandwich board, or carrying a placard on a pole, bearing the phrase.
Don't be like him John.
Has Trumpy given us a date yet for carpet bombing the other 3 nations at the 4 Nations Hockey Tournament?
Hmmmm, maybe the end really is nigh.