Invest Significantly at the Maximum Point of Pessimism 1912000, the NASDAQ 100 P/E reached 134.7, four to fi ve times the
P/E ratios of companies in the Dow Jones Industrial Average or the
S & P ’ s 500 Index. The NASDAQ Composite Index reached a P/E
ratio of 245! 8 Again there was no value or margin of safety by buy-
ing these equities at these ridiculous valuations, and being on the
short side would not have been deemed a speculative activity.
It would be unfair and ignorant to leave out one very crucial
aspect of participating in short sales: the consequences of time.
Investors who short a stock are borrowing those shares from their
brokerage house and making the investment on a margin account
(on borrowed funds). This means that unlike long investments that
do not require the use of margin (although many investors choose
to do so), a short position that goes against you can require you to
deposit additional capital or sell other securities in your portfolio
to raise the necessary capital. In other words, investors who are cor-
rect in their analysis of shorting a stock can still lose money on the
trade if the stock continues to go up before fi nally coming down to
more realistic valuations. This was the case for many investors in 1999
who correctly concluded that the NASDAQ Composite Index was
grossly overvalued at a P/E of 100. Unfortunately, before the valua-
tions headed south to more realistic levels, the P/E ratio climbed to
over 245, effectively wiping out some investors who were overexposed
on the short side. In hypothetical terms, an investor can correctly
short a stock trading at $ 100, but months later, the shares can easily
be trading for $ 200, at which point a capital infusion may be required.
Without the additional capital, the investor must sell and is forced to
take a loss. Yet several months later, the shares could be trading at
$ 20. The bet was correct but if an investor enters the position early
and the shares continue to rise, the result could be a painful loss. The
asymmetry of shorting is that you can be more patient being long and
wrong than being short and wrong. This asymmetry serves to discour-
age the short selling of stocks. Many of the myths cited run together,
further indicating that value is found in many ways.CH009.indd 191CH009.indd 191 9/2/09 11:49:59 AM9/2/09 11:49:59 AM