By Rodrigo Campos and Sam Forgione
NEW YORK (Reuters) - After years of hiding under their desks, short sellers are re-emerging - slowly.
Investors who make a living betting that stock prices will fall are happy to forget 2013: The S&P 500 <.SPX> gained nearly 30 percent while Credit Suisse's index of hedge funds with a dedicated short bias lost 25 percent.
Buying the most heavily shorted stocks was a much better bet than the S&P 500: A list of top shorted stocks from SunGard's Astec Analytics beat the S&P 500 by 26 percentage points on average last year.
But with the Federal Reserve beginning to cut back on its bond buying - in a withdrawal of the stimulus that underpinned the rally - there's hope for short sellers in 2014.
Jim Chanos, president and founder of Kynikos Associates and one of the most prominent short sellers, said the market is primed for people like him and as a result he has gone out to raise capital.
"Now I think is not a bad time to be raising capital for what we do. When we got a rough going in the mid-90s, that was exactly the time to raise capital," Chanos said, adding it was better to do this when critics viewed him as "like the village idiot and not an evil genius."
Already, there are signs 2014 may be different. Stocks haven't been rising as a herd in the way they did in 2013, and some of last year's high-profile winners are being re-examined.
Electronics retailer Best Buy Co
The 50-day rolling correlation between the S&P 500 and its components peaked last year in May at 0.73, soon after Fed Chairman Ben Bernanke first broached winding down the stimulus.
It dropped to 0.5 in October before bouncing back late in the year, but has since resumed its decline after the Fed announced cuts to its monthly bond buying, according to data from Bespoke Investment Group, a financial research firm based in Harrison, New York.
Bill Fleckenstein, president at Fleckenstein Capital Inc in Seattle, a notable short-seller who closed his short fund around the time the market bottomed in 2009, said he was about to start the process of raising money for a new short fund.
"We're about done with the document and I'll be marketing it officially very shortly, like within a week," he said.
That's not to say he is brimming with confidence - not yet.
"It's dangerous to be short still, but we might be building toward a moment - whether it's two weeks from now or 10 months from now I don't know, where the market becomes quite vulnerable," said Fleckenstein.
Don Steinbrugge, chairman of Agecroft Partners, a global consulting and third party marketing firm for hedge funds, said "long/short" equity - a strategy betting both on and against stocks - will see the most demand among all hedge fund strategies this year.
Long/short equity represented more than 40 percent of the hedge fund industry assets before 2008. The sector then experienced large outflows to other hedge fund strategies including commodity trading advisers (CTAs) and various fixed income-oriented strategies.
Its market share of industry assets bottomed out at approximately 25 percent in the beginning of 2013.
"Last year saw this trend reverse, and we expect very high demand for long/short equity in 2014," Steinbrugge said.
In fact, 2013 saw record inflows to long/short funds of more than $20.5 billion, up from $5.7 billion in 2012, according to data compiled by Morningstar.
Neuberger Berman Group LLC is taking advantage of the environment. The New York-based investment firm recently launched its second mutual fund that employs external hedge fund managers to manage its assets. The Neuberger Berman Long Short Multi-Manager Fund will employ the "long/short" strategy.
Long/short funds are slowly shifting toward the short side, though for now they're still aligned bullishly.
Their long/short ratio sits at 55 percent, according to Credit Suisse, down modestly from the beginning of the year. They had built short positions late in 2013 and the ratio did fall to about 47 to 48 percent in mid-November, until the year-end rally caused hedge funds to cover those positions.
UNDER THE MICROSCOPE
In the last week, S&P 500 companies that have seen the biggest increase in shares borrowed for short bets according to Markit include Borgwarner
Internet retailers TripAdvisor Inc
"There's growing interest on (shorting) a number of stocks, concentrated in areas that did well last year," said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management in Menomonee Falls, Wisconsin.
In 2013, just one of Astec Analytics' 10 most shorted stocks of the year made it to Markit's list of top 20 performing North American shorts - department store group J.C. Penney
Still, going short Penney, whose sales collapsed after bad missteps by management, was enough for some.
Suvretta Capital Management, founded by a former portfolio manager for top investors George Soros and Steven A. Cohen, told clients this week its bet against Penney shares helped contribute to solid returns for its long/short strategy in the last two years.
"On the short side, we have now generated profits three times (generating a total return of approximately 130 percent) in the past two years with our J.C. Penney positions," Suvretta Chief Investment Officer Aaron Cowen said in a client letter obtained by Reuters.
"Biotech is in full bubble mode, meaning companies that have no prospects of a drug continue to grind higher," said John Hempton, chief investment officer and founder of Bronte Capital, a Sydney, Australia-based asset management firm that often takes short positions.
Short sellers say they believe bulls may be getting too confident. The S&P 500's forward price-to-earnings ratio is at its highest since mid-2007.
Goldman Sachs, in a recent note, expressed concern that investors expect P/E multiples to continue to expand to a level that would match the 1997-2000 technology bubble.
"Short selling over the last two years has been a hedge against profits," said Douglas Kass of hedge fund Seabreeze Partners Management Inc. But he said recent disappointments from companies as varied as Ford, Intel, and Elizabeth Arden are signs that the "tide might be turning."
(Reporting by Rodrigo Campos and Sam Forgione; Editing by David Gaffen, Jennifer Ablan, Martin Howell and Sophie Hares)