Short Selling in 2013: Why These Billion-Dollar Bets Went Bad - And What's Ahead

Short sellers got burned this year because they forgot these "golden rules" of investing...

If you looked at holdings of hedge fund barons William Ackman and David Einhorn at the start of 2013, it looked like 2013 was a year for short selling.

In December 2012, Ackman placed a $1 billion bet that Herbalife Ltd. (NYSE: HLF), which he calls "a pyramid scheme," would fail. Einhorn bet against Green Mountain Coffee Roasters Inc. (Nasdaq: GMCR) back in October 2011.

But HLF shares have doubled this year. And GMCR is up close to 74%, as its ubiquitous K-Cups deliver single "doses" of coffee to offices and homes worldwide.

Hedge funds that had big short positions this year have seen their gains almost zeroed out, offset only by profitable long positions. Or they are sharply down.

In fact, we're in the worst short market in a decade, according to recent analysis by The Wall Street Journal. Short-selling activity is down 53%.

"It's actually more painful now than it was in '99," veteran short-seller Andrew Left told The Journal.

The Russell 3000's (RUA) list of the 100 most heavily shorted stocks has actually outperformed the broader index. Tesla Motors Inc. (Nasdaq: TSLA), Zillow Inc. (Nasdaq: Z), Netflix Inc. (Nasdaq: NFLX), SUPERVALU INC. (NYSE: SVU), and Yelp Inc. (NYSE: YELP) - all heavily shorted stocks - have absolutely clobbered the Russell 3000, the Dow Jones Industrial Average, and the S&P 500.

SuperValu, the "worst" performer here, is up nearly 204%. Tesla is up more than 380% for the year.

Anyone shorting these stocks on margin is facing devastating losses. Some have probably already arrived in Paraguay on a fake passport...

But not everyone lost big this year in the short market. In fact, Money Morning Capital Wave Strategist Shah Gilani has found some that have returned more than 100% even as the bulls run on... and on... and on.

So, how did these famed investors get it so wrong?

When Short Selling Goes Wrong

Talking about this year's short-selling losers, Gilani repeated the useful adage: "Bulls make money and bears make money. Pigs get slaughtered."

Gilani said the approach to successful short selling in this "aging bull" has to include discretion - and that's where the big-name investors failed.

According to Shah, "the big short players who got trounced - Ackman was the biggest loser - were exceedingly arrogant... they forgot the golden rules. Never take on a position so large that other traders can force your hand, to be forced to sell or cover your short. No person is bigger than the market."

Shah added that ostentatious short sellers make for attractive targets themselves.

"When you take a short position with 25% of shares outstanding, you're inviting me to squeeze you. You'll have a lot of shares to buy back if the trade goes against you."

Also, this year's short sellers forgot about the U.S. Federal Reserve.

The "Un-Shortable" Market of 2013

U.S. gross domestic product (GDP) grew by 2.5% in the second quarter. That kind of growth just isn't worth writing home about, not when China is putting up numbers like 7.7%.

The "official" unemployment figures keep improving, but are still high. And the dismal "real" U6 figure is more than 14%.

What's propelled this market higher despite all the economic reasons for it to fall is that the Fed has the money-hose on, full bore. And, brother, it is still raining.

This is why markets rallied even with slow GDP growth. That's why the market sees what can only be described as terrible unemployment figures, which show more than 7% of Americans aren't working, and a rally follows.

The Dow has tacked on nearly 73%, and the S&P 500 nearly 83%, since quantitative easing (QE) began five years ago.

In the end, a five-year bull market, almost completely divorced from economic reality, just doesn't turn on a dime. And we haven't seen any of the truly market-thwarting events that might open the gates for a bear run.

But this 54-month bull market will not have the Fed to power it forever... Here's what investors should look for going forward.

Short Selling in an "Aging Bull"

Effective short selling requires the proper attitude, the proper perspective - and a willingness to stay off the radar.

Gilani said, "At Capital Wave Forecast, we made small, defensive bets and took small losses. And so we had some triple-digit winners when our shorts worked out. But we took our profits quickly. We were lucky; the bull turned our positions around and they're mostly higher now. You can't get greedy picking tops or bottoms, like Ackman did."

For now, one of the best ways to capture short-sale gains, without the margin and with far less risk, is to select an inverse exchange-traded fund (ETF) with exposure to areas that are likely to see declines, such as ProShares UltraShort Basic Materials (ETF) (NYSE Arca: SMN) for basic materials or ProShares UltraShort Real Estate (ETF) (NYSE Arca: SRS)for real estate. There's an inverse ETF to short anything.

Shorting currencies, like the Australian dollar and CurrencyShares Australian Dollar Trust (NYSE Arca: FXA), earned Capital Wave Forecastreaders more than 100% in just a few weeks. The next likely currency to short would be the euro, as oil supply worries (read: Syria) set in.

But this is not a short seller's market - yet. This is still a game of picking individual down sectors and the odd stock to short. Insider selling can be a great indicator of a compelling short.

Investors should limit their exposure and remain adaptable to changing conditions in order to keep playing the bull market - all while waiting for the other shoe to drop and a full bear to begin. Remember, as Shah Gilani says, the only way not to make money is not to be in the market.

Something to watch: George Soros' 13F filings have revealed a huge short position - puts totaling 1.2 million units - on the SPDR S&P 500 ETF Trust (NYSE Arca: SPY). This position, held since the beginning of the year, has tripled twice in the past two quarters. Soros bet around $1 billion each time when he shorted the pound sterling in 1992, the yen in 2012, and the Australian dollar in 2013. Now he's betting against the entire stock market for similar stakes.

Maybe he has the magic touch, more so than Ackman or Einhorn. Maybe he knows something we don't. Maybe the end of the bull market is nigh...

Or maybe he's setting himself up to lose like the rest of the short bettors at the hedge funds.

To learn more about Shah Gilani's Capital Wave Forecast, click here.

When the bears finally do start their run, you'll need this weapon in your trading arsenal. It's Shah Gilani's favorite way to protect a portfolio - and make big money in bad times. Click here for the secret.