The ASX 200 is getting smashed, here’s how to protect yourself (and maybe even profit from it)

Darn that Jerome Powell! Social media tells me he’s responsible for all my portfolio’s woes this week!

Not exactly. Despite social media’s innate ability to deliver quality news and opinion, this really couldn’t be further from the truth. JP is just doing his job. Considering the US economy didn’t fall off a cliff after a global pandemic, and his Federal Reserve pretty much nailed the post-pandemic inflation threat – I’d say he deserves some sort of medal (President Trump? 🤔).

If there is some fault to apportion for your portfolio’s terrible performance this week, I’d blame the market analysts who had inaccurate expectations of the current macroeconomic environment and the Fed’s likely response to it – that’s ultimately why prices have corrected so sharply this week. Expectations were wrong, not the Fed.

As of roughly 6am Thursday morning local time, those same market analysts collectively were forced to change two cells in their giant, fancy stock valuation spreadsheets titled “Cash Rate 2025” and “Cash Rate 2026”. Both cells got a +0.50 applied to them. That’s how much the Fed ratcheted up its forecasts for its official cash rate at the end of the next two calendar years.

The upshot is that higher interest rates equate to lower stock prices. This is because:

• A higher cash rate impacts the rate at which analysts discount the future earnings of stocks (i.e., in their giant, fancy spreadsheets!). A higher discount rate flows through to lower stock valuations – and stock prices immediately appear overvalued post-adjustment compared to pre-adjustment.
• Higher interest rates, more generally, reduce company profits as it increases costs of funding, but also as it reduces consumption – it usually hurts company revenues too. Lower company profits equal lower stock prices.
• Higher interest rates increase the risk-free return on alternative asset classes like bonds. Investing in risky stocks (yes, as you’ve been reminded this week – stocks are risky) is increasingly less attractive the higher the returns on risk-free bonds climb.

The long and short of it

Well, that’s what happened. Here’s what you might want to do about it. Get short.

Short selling allows investors to profit from a fall in an asset’s price. It provides investors with an invaluable strategy to ride out market volatility, and potentially even to profit from it.

If you’re not proficient in short selling, this is the article for you. Firstly, consider the typical investment goes like this: Buy first, sell later. We do this because we believe the price of an asset is about to appreciate. If it does, you’ll make a profit. If it doesn’t, you’ll make a loss.

Short selling just puts the buying and selling components the other way around. We short sell when we think the price of an asset is about to depreciate. No doubt, at some time, I’m sure you’ve been confident a stock is about to fall. This is exactly when you’d want to get short.

When we short, we sell first and buy later. How can I sell a stock first? I hear you thinking. I don’t own any...

You can’t. If you did, this would be called “naked” short selling and it’s against the law! To legally short sell, you must first borrow the stock from someone who already owns the shares.

This process is handled seamlessly behind the scenes by your broker. First, you’ll need to set up a “stock borrowing facility”. Generally, this is not something discount brokers do – but you can check. Many short sellers also use derivatives like options and contracts for difference (CFDs) to go short – but I will leave the investigation of these instruments to you.

The bottom line is, when you type 100 shares into the quantity box in your broking ticket, the next thing you want to do is hit the “SELL” button. Your broker’s trading system instantly checks to see if you own any of the stock in question, and if you don’t – it automatically knows you’re intending to short sell.

After you’ve hit the sell button, you’re short. There, you did it!

What happens now? Not much, really. The price of the stock changes as it would if you didn’t go short, just like with any other investment. Also, just like with any other investment, it’s now up to you when to get out.

Ideally, this occurs after the price of the stock has fallen. Remember, we want the price of the stock to go down when we short – if it goes up, we’re going to lose.

At some stage, you’ll need to hit the “BUY” button for the full number of shares you’ve traded to “close out”, or “cover” your short. Then, as with any trade, the difference between your initial and final transaction price (less transaction and holding costs) is your profit.

It works like this:

Let’s say we thought all of those short sellers in Pilbara Minerals (ASX: PLS) weren’t crazy, but they had just done really great research and realised the stock wasn’t a bargain – but rather that it was grossly overvalued.

• On 4 March 2024, we decided to short PLS shares at $4.50.
• We go to our broking platform, enter 100 shares in the quantity box, and hit the SELL button.
• Our broker sees we don’t already own any PLS shares and opens a SHORT trade for 100 PLS shares on our behalf.

Today PLS is trading at $2.10. That’ll do, we tell ourselves. We go to our broking platform, dial up a PLS order ticket, and enter 100 shares in the quantity box. Then we hit the BUY button – TRADE CLOSED.

As all the shorted PLS shares are covered back, we have no further obligation. Our profit is (100 x $4.50) – (100 x $2.10) = $240.

Having the intent and ability to short sell literally doubles your investing opportunity. Well, not quite – not all ASX stocks are short sellable. There’s a list on the ASX website, and yes, as you know – PLS is on it and it’s been one of the most consistently shorted ASX stocks throughout 2024.

Mind the squeeze…

Plenty has been said about “evil and unscrupulous” short sellers depressing the stock prices of otherwise quality ASX companies. I’m not going to debate the “quality” of the companies that short sellers choose to target, but I suggest that like any professional investor – short sellers do careful due diligence as to which companies’ stock prices are most likely to fall.

If you don’t agree with them, well:

1. That’s what makes a market – buyers and sellers with different opinions – at some point the stock price proves either party correct; and
2. Short sellers run the risk of losing when the price rises, just as regular share holders run the risk of losing when it falls.

Note in our case study for example, if the price of PLS went up to $10, we would have had to pay $1,000 to repurchase the shorted PLS shares, and the result would have been a $550 loss.

Also consider, because there’s theoretically no limit on how high PLS's stock price may go, there’s theoretically no limit to the potential loss. The prospect of potentially unlimited losses on a short trade is a key reason why a "short squeeze" might occur. A short squeeze is when investors scramble in a panic to close their shorts, driving the price of the stock in question through the roof (Um, wasn’t there supposed to be a short squeeze in PLS this year? 🤔).

If you can’t beat ‘em, join ‘em

Ok, now you know about short selling. This is the good bit – it's where you can find a bunch of stocks that might be suitable to short – it’s called ChartWatch ASX Scans. In ChartWatch ASX Scans, I publish two lists each day – one of my favourite uptrends and one of my favourite downtrends.

As a trend follower (i.e., I can only buy stocks in uptrends and sell, avoid, or short sell stocks in downtrends), I suggest you keep an eye on the Downtrends lists for potential short selling opportunities.

This year, there have been plenty of them. 2024 is one of the few years I can remember where different segments of the ASX so spectacularly moved in opposite directions. There were dozens of fantastic uptrends in Technology, Consumer Discretionary, Financials, and at times, Real Estate Stocks. Similarly, there were just as fantastic downtrends in dozens of Resources and Energy stocks. 

As far as a trend follower was concerned: It was a veritable smorgasbord of trading opportunity in 2024.

Note also, that ChartWatch ASX Scans only effectively began on 1 June, so the data below relates only to the period since then.

Before you check out the list, this is perhaps the most important takeaway from this entire article:

Even if you didn't use the ChartWatch ASX Scans Downtrends lists to go short, if you only used them to figure out which stocks to avoid or which stocks to consider cutting from your portfolio – you could have avoided potentially dozens of 2024 investing disasters!

The fifth most Featured Downtrend of 2024 is Boss Energy – Uranium stocks were flying until mid-year, and that's when my trend following model picked up on several developing downtrends within the sector. I am particularly proud of just how precise my model was in picking up the transition from long term uptrend to long term downtrend here.

This article first appeared on Market Index on Friday 20 December 2024.