Carl Icahn’s outlook for the stock market is grim. The octogenarian investor reckons that unless the federal government stimulates the government with more spending, a “day of reckoning” looms.
Icahn didn’t suffuse “day of reckoning” with a precise definition, but it is easy enough to infer he means a hard sell-off in stocks. A recent SEC filing shows that Icahn Enterprises (NASDAQ: IEP), Icahn’s primary investment vehicle, has a 149% net short position. In other words, the value of Icahn’ s short positions – stocks and other financial securities borrowed and then sold – is worth 149% more than the value of his long positions.
Icahn’s goal is to make money on a stock market decline through short sales. Icahn has borrowed stock and sold it. He now hopes to buy the stock back at a lower price. Shorting is still a buy-low, sell-high strategy, except in reverse: The sale occurs first and the purchase occurs second.
I would tread carefully in following the current Carl Icahn strategy into the world of short selling, especially when shorting individual stocks.
For one, Icahn has been wrong so far. His short positions were down 8.4% in the first quarter. What’s more, there’s hardly a consensus among celebrity investors that a market correction is imminent. The most celebrated celebrity investor, Warren Buffett, warns dire prognostication shouldn’t be taken as gospel. Low interest rates, which appear to have been institutionalized, allow for higher investment valuations compared to the past, so Buffett reasons.
What’s more, Icahn can be right and still get it wrong. The dreaded short squeeze, regardless of how overpriced a security appears, is a constant threat. A quote attributed to economist John Maynard Keynes goes, “The market can remain irrational longer than you can remain solvent.”
Ask celebrity investor Bill Ackman if Keynes’ words ring true.
Ackman has spent the past two years attempting to convince all within earshot that his long-time short Herbalife (NYSE: HLF) is little more than a pyramid scheme. (I agree with Ackman’s assessment.)
Nevertheless, Herbalife shares recently hit a 52-week high of $66.26. Herbalife trades at more than double Ackman’s break-even price of $31 a share. Ackman is down nearly a billion dollars on his Herbalife short. Investors are aware of Ackman’s large short, which is a form of pent-up demand. They know that he will eventually have to repurchase Herbalife shares.
An irrational market isn’t your only concern. While you’re short a stock, you’re responsible for covering dividend payments. Your broker could also charge interest on your outstanding position. Worse yet, your broker could call back the shares at an inopportune time, forcing you to buy back shares at a higher price than you sold.
And with a short sale, your loss is theoretically unlimited, while your gain is capped. The sky is theoretically the limit, but zero is the actual limit a stock can fall.
If you agree with Icahn’s prognosis, you can avail yourself of safer options. An inverse ETF is one safer option.
An inverse ETF is bought and held just like any stock. The difference is that the inverse ETF moves contra to its corresponding investment. One goes up, the other goes down, and vice versa. For example, the ProShares Short S&P500 (NYSEArca: SH) moves contra to the S&P 500. If you anticipate a broad-based market sell-off, the ProShares Short S&P500 is worth considering.
ProShares Short S&P500 isn’t the only broad-based contra investment. The ProShares Short QQQ (NYSEArca: PSQ) trades contra to the Nasdaq Composite Index; the ProShares Short Russell2000 (NYSEArca: RWM) contra to the small-cap Russell 2000 Index.
You’ll also find inverse ETFs that trade contra to most business sectors: The Short Financials ETF (NYSEArca: SEF) trades contra to bank stocks; the Short Oil & Gas ETF (NYSEArca: DDG) trades contra to the U.S. oil and gas producers. There are many more.
For most investors, long is the way to go. But a sliver of your portfolio allocated to a contra investment, like an inverse ETF, will smooth out the ups and downs in your investment portfolio, thus making for a smoother ride over the long haul.
How to Sleep Easy at Night
Is the economy keeping you up at night? Do you worry there’s another crash just around the corner? If so, you can stop worrying right now. All it takes is a few minutes.