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Shorts destroyed: The risks of betting on a bubble bursting

The jury's out on Janet Yellen as a Fed Chair but if she ran a hedge fund she'd already be out of business. Last week in her semi-annual policy report to Congress, Yellen strayed from macroeconomics into stock picking, suggesting that valuations in social media, real estate and biotech seem extended. If she was worried last week she's gotta be terrified today after a more than 4% run higher in Social Media (SOCL) and Biotech (IBB) ETFs over the last week.

On the upside Yellen probably handled her setback with more stoicism than hedge fund manager Bill Ackman. Ackman got choked up during his three hour, several hundred slide attack on Herbalife (HLF) this week. Ostensibly he was saddened by the way he claims Herbalife targets low-income entrepreneurs, but the fact that shares of Herbalife went up 25% when Ackman failed to "destroy" the company as promised probably didn't help.

Yesterday saw explosive ramps in some of the most widely shorted stocks in the market. Zillow (Z), Trulia (TRLA) ripped 15% and 30% respectively on rumors of a merger. SodaStream (SODA) jumped 10% on buzz that it might take itself private. All three of those stocks have more than 30% of the shares outstanding held short by funds and individuals. Zillow and Trulia are levered to both social media and real estate. SodaStream might as well be Sunbeam for a new millenium. Doesn't matter. If you were short those companies yesterday your fund is being fitted for a toe-tag today.

According to Hedge Fund Research, the average shorts biased fund has lost 10% a year for the last 4 years and was down another 5% at the end of June this year. I guarantee that's gotten much worse this month.

The problem with shorting a M&A frenzy is that it's all but impossible to control your risk. Months of work gets tossed out the window on a buyout rumor and stops won't help you. The truth of both the dot.com bubble and the financial meltdown is that plenty of people saw them coming and got crushed anyway.

If you hate this market the safest way to express that doubt is by taking two positions: cash and fetal. If you insist on shorting anyway I strongly recommend you first read the March 2000 letter from Tiger Management's Julian Robertson to his investors. In the note Robertson lays out the entire collapse of the internet bubble with frightening accuracy. He also announces the closing of Tiger after 20 years and an 85-fold gain. I'm not suggesting you get long stocks and ride the wave if you're not so inclined. I'm cautioning you not to confuse academic observations with an investment thesis. We've entered a dangerous period in the market for bulls and bears. Now seems like a good time to step back and do a little homework.

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