Endangered shorts: As stocks skyrocket, skeptics are surrendering
The Wall Street skeptics are gone.
As the stock market hit record highs – undefeated by recession, pandemic or dangerous bubble warnings – activity fell to an almost two-decade low for traders known as short sellers , who make their money betting stocks will fall.
It hardly saddens anyone. From small investors to members of Congress, critics describe short sellers as dealers in pain. People around the world celebrated earlier this year when GameStop’s shares suddenly skyrocketed, causing short sellers to lose billions of dollars in losses. Many have called this a long overdue comeuppance.
But academics and short sellers themselves say they are providing an important service right here: fighting stock prices that can rise too high, too fast. Despite concerns about the pace of the economic recovery and high inflation, the S&P 500 has hit 65 all-time highs so far this year, with the latest coming on Monday.
Some critics say stocks look overpriced, with broad measures of value near all-time highs. Fewer short sellers in the market means there is less selling pressure pulling these prices down. It can also mean fewer investors looking for overvalued stocks or looking for fraud.
“This is what short sellers do, they lean against the wind,” said Charles Jones, professor of finance at Columbia University’s business school, who has researched short selling. . “If you have short sellers who aren’t afraid to do this, you won’t get prices that are too high or too low, which I think we want when we allocate capital.”
Jones’ research on Wall Street in the late 1920s and early 1930s, for example, focused on a group of stocks that were particularly expensive to sell, which discouraged short sellers from targeting them. They then posted returns that were 1 to 2% per month lower than other shares of a similar size, suggesting that they had been overvalued.
When investors sell a stock short, they borrow the stock from someone else and sell it. Later, if the stock falls as the short seller expects, he can buy the stock, return it to the lender, and pocket the price difference.
So it’s no surprise that short sellers are regularly blamed for artificially driving down stock prices. During the 2008 financial crisis, days after the Lehman Brothers bankruptcy, US regulators temporarily banned the short selling of financial stocks, fearing that short sellers would undermine already low confidence in them and trigger a rush. on the system.
Almost four years later, however, a study by a New York Fed economist and professors from Notre Dame suggested that the ban did little to slow the decline in bank stocks, which have dropped anyway. The restrictions have also hampered trading in bank stocks, increasing trading costs in the stock and options markets by more than $ 1 billion, according to estimates.
Short selling activity has been trending down since July 2008, a few months before this temporary ban. At the time, it was almost double its current strength, accounting for 2.61% of all stocks in S&P 500 companies. Only 1.35% of all stocks in S&P 500 companies were sold short in August, according to data compiled by FactSet.
The relentless rise in the stock market since 2009 has prompted investors to withdraw dollars from short-selling funds, helping to narrow the ranks of opponents. Why cut short when everything is going up?
âYou have to look at what is driving the market to all-time highs,â said Carson Block, founder of Muddy Waters Research and one of the best-known short sellers in the industry. “It is certainly not that humanity is at our greatest state of all time.”
Instead, he said one of the main reasons was the ultra-low interest rates set by the Federal Reserve to boost the economy. These low rates have sent waves of liquidity into the stock market, and critics say they are driving prices up indiscriminately and allowing weak companies to hold on.
Block specializes in eliminating fraud, and one of his first victories was that of Sino-Forest, a company that was once Canada’s most valuable publicly traded forestry company. Block published a report in 2011 calling the company a “multibillion dollar ponzi scheme” that overestimated the amount of its investments in timber.
His actions quickly plummeted as the report reverberated and the company pushed back the charges. But it ultimately collapsed into what an Ontario securities regulator called “one of the biggest corporate frauds in Canadian history.”
Short sellers were also credited with helping publicize the financial practices of Enron and Tyco International, two of the biggest cases of corporate fraud in the United States, in the early 2000s.
Of course, sometimes short sellers are wrong. Tesla has been a favorite target for years, with short sellers betting that founder Elon Musk’s visions for the electric vehicle company were too grandiose. Tesla recently posted a record quarterly profit and is one of the few companies in the world worth $ 1,000 billion.
Not all short investors bet only on stocks on the downside.
Take the example of Marc Regenbaum, portfolio manager of the Neuberger Berman Long Short fund. Most of the mutual fund’s investments do well when stock prices rise, but it reserves some of its holdings for short-term short-term sales.
Regenbaum acknowledges the frustration that comes after identifying seemingly good short candidates and seeing their prices soar. A rising tide has pushed up nearly 90% of S&P 500 stocks in the past year. But he said he still believed that shorting certain stocks could help manage the fund’s risk and provide more stable returns during turbulent markets.
âEveryone sees short selling as this element of speculation and absolute return, rather than hedging things and offering a smoother ride to the underlying investors,â he said.
Doug Ramsey, chief investment officer of the Leuthold Group, said the average market share recently appeared to be more expensive than it was during the height of the dot-com bubble of 2000, based on several metrics. The Leuthold Grizzly Short fund has reduced its size by about half in three years, with assets of $ 51.3 million at the end of June.
Ramsey said the stock market performance between good and bad companies could separate again, providing better rewards for short sellers, after the Federal Reserve withdraws support from the markets.
Short sellers need help. The average equity mutual fund that reserves part of its portfolio for short selling has generated an annualized return of 7.2% over the past five years, less than half the return of an S&P fund. 500, according to Morningstar. The difference from year to year can be even more marked. Consider 2013, when the S&P 500 returned 32.4%. Hedge funds with a short selling bias lost 18.6% that year, according to research firm HFR.
But the Fed announced earlier this month that it was cutting back on its monthly bond purchases. Many investors expect him to start raising short-term interest rates, which would be the biggest move, next year.
Block, the activist short seller of Muddy Waters who sometimes struggles with his critics and enemies on Twitter, said he has no plans to quit smoking. At least, not so much that he thinks he sees the economy and the markets being mismanaged by people he sees as fraudsters.
âI think it’s the right thing for me,â he said. “It’s a way of trying to monetize my constant state of alarm, my constant state of dissatisfaction with the dystopia that is unfolding all around us.”