It seems that the only way to make money in the short-term in the current stock market environment is to go short, or to make a bet that the market will continue to decline. While this can be a sound strategy to make money for those who become proficient at it, there are some practical problems for the average investor.
For the uninitiated, short selling involves borrowing stock that you don't own, and selling it, with the belief that the price will decline. When the stock falls enough to satisfy, you buy the stock back at a lower price than you bought it - making a profit.
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Most mutual funds are prohibited from selling short at all, or are allowed at most, a minimum amount. This puts individual investors at a disadvantage since most are invested in the market utilizing mutual funds. Thus they are typically net long, meaning their portfolio will benefit more from an upward move in the market rather than a downward move.
If an individual wants to go it alone, and sell short in his or her own account, they must first borrow stock through their broker. Sometimes this can be difficult since brokers typically will lend to larger institutional customers first. Investors can also pay higher interest rates on the borrowed stock. (To learn more about short selling, be sure to check out our Short Selling Tutorial.)
Banks Gone Wild
The financial sector has been one of the prime areas of short selling the last two years. The list below shows the top four bank stocks with a market capitalization of more than $200 million that were sold short as of January 30, 2009.
|% of Shares
|Bank of the Ozarks
|Cathay General Bancorp
|Data as of January 30, 2009|
Zions Bancorp is the largest bank on the list. The company reported earnings last week and has a net loss of $498 million due to higher losses from loans and goodwill impairment. Its ratio of nonperforming assets to net loans and leases reached 2.71% at the end of 2008. Bank of the Ozarks Inc. is an interesting one to be so heavily shorted. The stock is actually up year-to-date, and so far its asset quality has not deteriorated as much as its peers. At the end of 2008, its non-performing assets as a percent of total assets was only 0.81%. However, it should be noted that the bank's loans and leases past due 30 days or more is at 2.68% of total loans, and it is logical to assume that some of these delinquencies will eventually filter into the non-performing category.
Cathay General Bancorp is a niche bank in California that serves the Chinese American community with operations also in Hong Kong, Shanghai and Taipei. In addtion, the bank is experiencing stress in its real estate portfolio. The company reported a ratio of non-performing assets to total assets of 2.1% at the end of 2008. These problem sets are concentrated in both residential and commercial real estate.
UCBH Holdings Inc. is another bank located in California, which has become the epicenter of bad loans during this credit cycle. UCBH also serves the Chinese community. The bank reported a $54 million net loss in the final quarter of 2008. Once again, the culprit was stress from its Real Estate Loan portfolio.
A large short position in a stock is not always a good thing, as one problem that might happen is a "short squeeze." This occurs when too many investors try to close positions and buy back stock at the same time, thus driving the price appreciably higher.
Short selling can be a profitable enterprise particularly during the bear market that is currently gripping the U.S. However, short selling is not without risks, and investors should tread carefully in this investing area.
To learn more about the causes of the troubles in the financial sector, read our article The 2007-08 Financial Crisis in Review.