From the table on the Horizons BetaPro website, it looks like a strategy of shorting both bullish and bearish leveraged ETFs would be profitable most of the time. However, the past year or so has been a rather volatile period and the year ahead will likely exhibit less volatility. In that case, the shorting strategy may not turn out to be as profitable as it would appear from the Sept. 31, 2009 table.

So, if one wants to give this strategy a try, some due diligence needs to be exercised to pick one’s spots carefully. The odds of success would be higher if one were to target the sectors likely to be most volatile, one of which seems to be the S&P/TSX Global Gold Bull/Bear index.

Another caveat might be the availability of ETFs to short sell. Brokers may not be able to find any units to lend to a short seller.

Securities lending occurs when mutual funds, exchange-traded funds (ETFs) and other institutional investors lend out securities in their portfolios to parties, mainly hedge funds, for short selling. Despite the body blow delivered by the financial crisis of 2008, it remains big business: $400 billion (U.S.) for stock lending on a global basis as of June 30 (down from the peak of $850 billion in 2007). The chart below (source: SunGard Astec Analytics as obtained from a Standard and Poor’s white paper) shows the trend (which, it will be noticed, is beginning to turn up again).

Among the SEC’s concerns and those of panelists at a Sept. 29 public roundtable are opacity and imprudent investing of the cash collateral put up by borrowers. A lack of transparency means regulators are hampered in discerning system-destabilizing risks. And the unfettered investing of cash collateral could lead to more collapses of the kind several lenders experienced in their lending programs during the past 12 months.

For example, a loss of over $600 million (U.S.) during the 12 months to March 30 was reported by California Public Employees’ Retirement System (Calpers). The pension fund was cutting out the middlemen and doing its own investing of the cash put up by hedge funds borrowing shares. They were, in fact, investing with borrowed money and when the hedge funds closed out their positions and demanded their collateral back, Calpers was compelled to sell positions to raise capital to return their cash.

But despite the hiatus of the financial crisis of 2008, the securities-lending train continues to gather momentum. Here are some recent developments:

• A global survey published Sept. 21 by RBC Dexia shows the practice of securities lending is still thriving despite the market volatility of recent months – only 17% of survey respondents (institutional investors) said they had dropped their securities-lending program (60% made no changes at all and the remainder tightened risk controls)

• Standard & Poor’s recently announced it has developed an index to track the cost of borrowing U.S. stocks from securities lenders at the wholesale level (which S&P hope will be used “as a tool to give market participants the flexibility to develop a variety of products used in hedging and speculation.”)

Yet, the federal government has taken on spending commitments that entail gargantuan budget deficits for some time and a tsunami in bond issuance. Current spending commitments include trillions of dollars for existing commitments such as Social Security, Medicare, etc. and the Iraq war — as well as trillions more for bailing out the financial system, propping up ailing industrial sectors, and massive fiscal stimulus package promised by the Obama administration.

At the same time, the Federal Reserve is creating credit at rates never seen before. As Northern Trust economist Paul Kasriel noted, the year-over-year increase (to November of 2008) in bank reserves is about ten times the previous high, which occurred in 1934. Deflationary forces are ascendant right now but one wonders for how much longer given the massive stimulus unleashed.

Shorting government bonds would thus appear to be a no brainer as risk appetite responds to signs of an upturn in economic growth and inflation worries arise anew. But what might not be so obvious is the timing of the trade.

Lags in the impact of stimulus measures could mean deflationary news will linger for awhile yet. More importantly, the Federal Reserve has stated it is committed to buying Treasuries to keep interest rates low until the crisis and economy stabilizes. China too will likely be a buyer of U.S. Treasuries as part of its strategy of suppressing the yuan to enhance the competitiveness of its exports.

So watching from the sidelines may be the strategy for now. Ways to short the bond bubble include going long on the ProShares Ultra-Short 20+ Treasury and ProShares Ultra-Short 7-10 Year Treasury Fund ETFs (but understand the constant leverage trap first) and short selling the iShares Lehman 20+ Year Treasure Bond ETF

Unlike the US, we have the uptick (or last-sale) rule here in Canada which is supposed to prevent the kind of “piling on” that the US and UK bans are supposed to put a stop to. (Read: piling on to falling financials.) Given, though, that some of the financials protected from shorts in the States are interlisted in Toronto, the OSC is worried about flood of cross-border action—”regulatory arbitrage,” as OSC chair David Wilson puts it in the release.

Here’s the list of companies on the OSC’s no-short list:

Aberdeen Asia-Pacific Income Investment Company Ltd., Bank of Montreal, The Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Fairfax Financial Holdings Limited, Kingsway Financial Services Inc., Manulife Financial Corporation, Quest Capital Corp., Royal Bank of Canada, Sun Life Financial Inc., Thomas Weisel Partners Group Inc., The Toronto-Dominion Bank, and Merrill Lynch & Co., Canada Ltd.

The short sellers are right of course about the rot in the U.S. financial system but they are underestimating policymakers’ ability to pull rabbits out of the hat. And policymakers will keep on ignoring the rulebook and reaching for rabbits as long as it takes, because the alternative is worse. Short selling is a hard way to make money anyway in the stock market — if only because of the long run tendency of stocks to rise by some 7% to 9% annually on average.

Yet, the abolishment of short selling does not necessarily mean stocks can now only go up. Take China. Its stock market has had one of the steepest declines (over 50%) during the past year even though short selling was banned throughout. There was a recent rally in Chinese stocks but it was linked to announcements the Chinese government is now going to prop up the stock market by buying stocks. How’s that for breaking the rules?

Many stock-market bloggers were outraged by the U.S. decision to ban short selling. But the preservation of free markets seems a lesser virtue compared to preserving the U.S. financial system, economy, and indeed, status as a world power.

Let’s acknowledge it: the U.S. is in a desperate competition with upstart emerging economies. The latter have made major inroads by pegging their currencies, suppressing domestic oil prices, banning short selling, currency controls, prohibitions on derivatives/options, and a host of other market manipulations. They aren’t playing by the free-market rulebook either. The U.S. may need to untie the hand behind its back with some interventionist measures of its own — until stability returns.

Why wait for a few more percentage points to take the gain, as several readers rightfully asked in emails and blog posts? I had said 50% for “silly psychological reasons” as I replied to one reader – i.e. that was the gain that would have offset the Nortel loss in one account.

Over the weekend, I read halfway through Timothy Sykes’ book, An American Hedge Fund, and came across a passage where he similarly held out for a few more points because that would exactly offset his loss on previous trades. His experience highlights the utility of having more objective criteria for buying and selling. He writes:

“I promised myself that I would hold [my short position] until I broke even from the two earlier trades. My paper profit now surged to $27,000, but I still didn’t take it. Within minutes, it turned into a $6,000 paper loss. I couldn’t chance another reversal, so I decided to cut my losses. Unfortunately, the quick reversal scared many other short sellers into trying to cover too … and I found myself chasing the stock higher … and was finally out … with a $28,600 loss.”

Preet Banerjee emailed in with his hedged trade on HOD. When oil was near $140, his mock portfolio bought HOD and several energy stocks to arbitrage the undervaluation of oil stocks relative to the commodity. That turned out well, he reports, and now he is unwinding the trade.

But I plan to put in a sell order for the ETF next week if and when a gain of approximately 50% is reached. The price of oil could keep falling to the marginal cost of production, which the LEX column in the Financial Times of London says is “around $70 a barrel.” But market forces rarely drive prices to their equilibrium in a straight line and if a reversal came now, it could be demoralizing to watch the gain evaporate when loses are piling up elsewhere thanks to the bear market.

Moreover, market forces are rarely left unmolested. Indeed, next week OPEC is meeting to discuss production cutbacks. And political disturbances could result in an upward spike. That would be a good time to go short again with the Horizons BetaPro NYMEX Oil Bear Plus ETF.