While the aim of business, as well as society, is progress and improving technology, rarely is every action considered a step forward. In sports, teams take the time to shed previously good players to develop the raw talents of new ones. Fans call these rebuilding years. In business, managers may let some employees go to make way for new technology and new business practices. They call this consolidation. Depending on one’s time horizon, goals, and vision these actions may simply be appropriate, but at a certain point, they are necessary. Accounting for this natural process, prices in the stock market may trend down on certain stocks for significant periods of time, only to rebound even stronger.
Companies or sectors going through these transitions generate market cycles. It is also important to know that sector cycles may or may not overlap, but when they do and the entire economy contracts, it’s possible to have a recession. Given that these business cycles and subsequent price movements are natural and inevitable, why do the majority of investors consider the safest, lowest-risk method of investing to be long-term, long-only investing? Our natural alternative is to invest on the long side for rising companies and be able to short on falling companies.
How to know when to use long and short investing
One potential rationale for long-only investing is the timing risk that comes along with shorting, whereby an investor may not have confidence in his ability to catch market cycles. Another potential rationale comes from the risks of being wrong on a short position. When an investor buys or goes long a stock, the maximum loss is 100% of his capital. But when an investor shorts, a stock doubling would result in 100% loss, a stock tripling would result in a 200% loss! In general, losses may be unlimited. Conversely, returns on being long may be infinite as a stock rises above price targets and gains momentum. On the other hand, the best scenario for someone with a short position is that the company is found insolvent or files bankruptcy, resulting in a stock price of zero and a return of 100%.
Being short dramatically increases the need for active management to balance out this inherent risk/reward circumstance. It also requires a significant amount of work and research to select the right stocks at the right time. Since the March 2009 market bottom, long/ short investing has been unpopular due to the active liquidity injections of the Fed through quantitative easing and the overwhelming upward trajectory of the market. Although the S&P 500 has returned roughly 390% from the bottom, this performance has come with ten or so peak to trough moves of 8% or more. Being active and willing to short can lead to significant outperformance during such periods. However, the media prefers to focus on the underperformance of most of the long/short strategies during the historic and unprecedented bull market of the last ten years. All this despite September to December of 2018 being the worst drawdown since 2009.
An investing strategy's ability to adapt
These days, it is possible to use technology and algorithms to perform the heavy research burden required to identify when a company is turning. A great deal of research has shown various indicators are surprisingly reliable when it comes to anticipating such things. An investment approach should, therefore, be flexible and active, allowing the short-selling process to contribute to performance at the right times.