Category: short selling

Bearing rules for selling short

1. Never fight human progress. I want to ride secular waves, not fight them. Tech and health care are mostly off limits from the short side. There are always exceptions, like Valeant Pharmaceuticals and Tesla, but if the stocks are simply overvalued, we’ll be a spectator. If anything, I’d rather be long clear winners, even if I have to pay up a little. This is a natural hedge against our short position.
2. Short companies highly vulnerable to the cyclical event. These are typically dependent on cheap credit in one way or another. They also tend to drink the Kool Aid during the boom and take on too much leverage.
3. Short consumer fads… when the stocks are priced as if growth will continue indefinitely. Canada Goose might be an example today, but it’s only on my radar for now.
4. Only short a stock if you see a path to a potential 75-100% decline. Otherwise, the risk/reward isn’t worth it. (There is a lower bar for bonds, but the same risk/reward formula applies.) That means the business will be impaired, which usually involves intensifying competition and indefensible moats. The ETF business is a good example.
5. Compartmentalize risk. Evaluate every position on risk/reward. Don’t assume your hedges will work (they often break at the most inopportune times). Don’t allow one losing position to swamp the rest of the boat.
6. Big trees will underperform. $1 trillion market caps of AMZN and AAPL are a good example. This doesn’t necessarily mean they qualify as impaired businesses or stocks that can go down 75-100%, but knowing they are highly likely to underperform over the next decade (after all, trees don’t grow to the sky) is valuable information. E.g., this could be the pin that pops the passive investing bubble.

Do short sellers contribute to panics?

I doubt it, coming from a hedge fund that was heavily net short going into yesterday’s mini-meltdown. While others were panicking, we were buying. (When they rallied the Dow 1,000 points on the initial news of Paulson’s $700 billion bailout scheme, we were selling.)

In fact, it is hard to imagine a professional short seller lasting long in this business by piling on when the market tanks. The Great Bull Market of 1982-2007 made mincemeat of this strategy. And in the past 18 months – generally a rewarding period for short sellers – numerous government interventions, meant to catch speculators off guard, rendered such a strategy suicidal. After 25 years of asset inflation and chronic moral hazard, the dedicated short selling community is all but extinct, making up perhaps 0.1% of all hedge funds. To imply short sellers had anything to do with the implosion of Countrywide, Fannie, Freddie, AIG, Bear, Lehman, et al. is ludicrous. (Yesterday, Wachovia opened down over 80% before those dreaded short sellers were even allowed to place an order.) Let’s not forget, the biggest short seller in the room, Jim Chanos, admitted he missed out on the troubles at Bear Stearns and Lehman Brothers.

The market is a mechanism for price discovery and the short seller provides a vital role in that process. The financial establishment (and their political handlers) bet their livelihoods on perpetually rising prices, thus their incessant attempts to subvert this process, and keep prices of homes, mortgages, and bank stocks elevated. Good luck.

In an article today, Lew Rockwell explained the futility of government trying to prop up prices:

You have to understand how ridiculous this whole debate looks to anyone who understands the price system. Let’s change the example from houses to apples to see how silly it is to suggest that falling prices can be made to rise. Let’s say that the Fed created an apple hysteria that drove the price from $3 per pound to $10. Stores loaded up and even used them as collateral for expansion. Suddenly the price collapsed to $5 and finally to $2.

Now government takes notice. What can government do to deal with the problem? It can try to boost the price of apples by forcing stores to raise their prices. But what about consumers? They won’t buy at $10. So the apples sit and rot. Maybe government should buy them all or force consumers to buy them. Also perhaps stores will just not buy any more at all. Government could force them to. But it can’t force them to stay in business. People can always walk away. So perhaps government can just buy the stores, all in the interest of keeping the price of apples up. But it will have to buy the apple-leveraged stores at a much higher price than the market would offer, so this is a bad economic deal on the face of it.

The tangles can get ever more complicated and billions and trillions can be spent. You can put everyone in a prison camp and force people at the point of a gun to buy and sell apples at $10. But in the end, the problem is still the same: the price of apples wants to fall. Nothing government does changes that one fact. To attempt to change it is like trying to change gravity. Of course, the government’s central bank can raise all prices through inflation to the point that apples do in fact cost $10, but this is purely cosmetic. In fact, in real terms, the price of apples is still $2. It is a pointless and destructive activity to try changing this. You only cause massive damage in the
attempt.

In fact, as Rockwell points out, lower prices have a cathartic effect:

It is not entirely clear why prices fall. It could be the worldwide economic slowdown. It could be that the markets are beginning to doubt the capacity of the Fed to actually achieve the hyperinflation that it wants, since banks have become quite risk averse. In any case, we need ever-lower prices on all things, including gas and groceries – and, yes, houses. This is the basis for economic recovery.

Just as in the 1930s, the political class is doing its best to thwart the price system. If successful, they will produce similar results… or worse.

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