Back in late OctoberSee Using 'Short' ETFs to Prepare for Correction

After all, stocks had gone up nearly 57% without any correction of 10% or more since March, despite a seemingly sluggish recovery and rising unemployment. So I bought shares in the ProShares UltraShort S&P 500 fund (SDS), which aims to double the inverse return of the S&P 500 index. In other words, for any given day, if the S&P 500 dropped 10%, this ETF would be expected to gain 20%. I said then, I m deliberately calling this an experiment, not a recommendation. I suggest that conservative investors let me be the guinea pig.

The guinea pig is back with his report.

It s long been my policy to avoid bets on short-term moves in the stock market. There are good reasons for this. No one else has been able to predict the market s short-term direction with any consistency, so why should I? Over the long term, stocks have tended to rise. So shorting the broad market is by its very nature a short-term bet. I only expected to hold the short ETF until a correction materialized, then sell. Right off the bat, my strategy violated one of my cardinal rules.

See Thanks to Santa Rally, a Selling Opportunity I bought the ProShares UltraShort QQQ fund, which aims to achieve twice the inverse return of the Nasdaq-100 for a single day. At that point, the Nasdaq Composite was at 2253. Still the market kept rising; the Nasdaq hit 2320 on Jan. 19.

Then I was vindicated somewhat. By Feb. 5, the Nasdaq Composite had dropped as low as 2100 intraday, or just under 7% below its level when I bought the short ETF. The Nasdaq-100 had fallen similarly. I was looking at a gain of over 8% in my UltraShort QQQ shares. Coincidentally, the S&P 500 dropped to 1063 the previous day, right where it had been when I bought the UltraShort S&P 500 fund.

But then what? I hadn t developed a clear-cut exit strategy. I had the idea I d sell the short funds when the Nasdaq Composite had dropped 10%, a standard correction. But it never quite hit that threshold. Still, I no longer had the sense that stocks were so overvalued. Much had changed since October. Corporate earnings were rolling in, and they were strong. Multiple indicators suggested the economy was indeed improving. Despite the decline, the market struck me as remarkably resilient considering all the bad news, such as worries about Greece and its potential default. And then, as I was pondering all of this, the markets resumed their climb. Last week the S&P 500 was back to 1076 and the Nasdaq to 2184.

I bailed out, a modest gain in my UltraShort QQQ shares offsetting a small loss in the UltraShort S&P 500. With transaction costs, I pretty much came out where I would have been had I simply held cash. Cash isn t a perfect hedge, but it achieves many of the same goals, without the transaction costs and without the risk of loss.

The short ETFs performed as advertised, but I doubt I ll be buying them again anytime soon. It may turn out I sold them prematurely, and that the long-awaited correction of more than 10% is just around the corner. But who knows? The Common Sense system which calls for buying stocks at thresholds of 10% declines, and selling on 25% increases -- provides a disciplined approach. But the default position is cash, not a short position. I don t get any pleasure out of betting against the market, especially when historically (and notwithstanding the lost decade of 2000-09), the trend is up. I found myself worrying inordinately about those short funds.

The problem with selling short which is really just the problem of selling, magnified is you have to be right twice. You have to know when the market is overvalued, and then you have to know when a correction has run its course. I know there are many successful short sellers, but I don t like those odds.