As the overall stock market rally continues, and the Dow has broken reached record highs, now seems like a good time to comment on why we haven’t yet made any short recommendations for 2007. After all, in a bull market, wouldn’t a proper contrarian be betting on the downside?

First and foremost, it’s important to remember that true contrarian investing does not entail simply contradicting what goes on in the marketplace for its own sake. It’s not that simple. Rather, the contrarian looks for situations where the market has mispriced an asset. Naturally this mispricing can occur on the upside as well as the downside, but that does not mean that it’s wise to go short in a bull market.

The truth is that we are not fans of short selling in general. There are a number of reasons for this. First and foremost, selling short is just a bad deal in most cases. Depending on the stock in question, you might have to wait for an “uptick” in price before you are allowed to short. You must borrow the shares in order to sell them, which can expose you to margin interest, depending on your broker’s policies. Even worse, if a dividend is paid out while you hold your position, you must pay it. Plus, you run the risk of the nightmare scenario of a short-squeeze. In simple terms, this occurs when the price of a stock jumps rapidly, and short-sellers find themselves without sufficient margin to hold their positions. The result is they are all forced to buy back the shares at nearly the same time, bidding up the price even further, and forcing investors to close out at the worst possible moment. All this adds up to the cards being stacked against the short-seller right from the start.

Apart from practical considerations, however, short selling just doesn’t jibe with our investment philosophy. We are investors, and we have always viewed short sales more as speculations. A short seller doesn’t take ownership interest in an enterprise — he merely bets on its downward movement. This is not to say we object to the practice. It is an important component of the marketplace, and leads to more efficient pricing. Further, there is no mistaking the fact that it can be very profitable. At the end of the day, however, the potential profits from short-sales are limited, as a stock can only ever go down to zero. The potential losses, on the other hand, are unlimited. We prefer to be on the other side, the side with unlimited potential, which is and always will be the long side.

The upshot is, in a bull market, we look for securities the market has ignored, or beaten down unjustly due to overreaction to short-term misfortunes. Granted, these opportunities are harder to find in a bull market, but they exist, and the beauty of the strategy is that undervalued companies may be swept up by the overall upward trend when the market inevitably discovers its mistake.

P.S. all that said, there are times when the conditions in favor of a downside play are so overwhelming that we can’t help at lest considering going short. Two companies fit the bill at present. Both are American icons, and household names. Both are effectively bankrupt, however much their accounting hocus-pocus may claim otherwise. Stay tuned for more details.