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Shorts Tuesday, February 23, 2021
In 1609, a merchant contracted to sell shares in the Dutch East India Company in the future, sending the company’s share price into a plunge. A year later, the authorities imposed the world’s first ban on short selling. Short sellers, or “shorts,” have been blamed for almost every financial crisis in the 400 plus years since the Dutch episode. Shorts came under fire after the U.S. stock market crash of 1929, shorts were blamed for the U.S. stock market crash of October 1987 and shorts were blamed for the collapse of Lehman Brothers in 2008.

“But there is no academic evidence that short sellers by themselves have brought a company down without other underlying reasons,” Paul Asquith, a professor of finance at MIT’s Sloan School told Reuters at the time. “Lehman was having problems and the shorts were there. But once Lehman started looking for a buyer, what happened? Nobody wanted to buy Lehman when they started looking at their books more closely. That tells you the shorts were right.”

Lehman’s financials were overleveraged and overvalued.

Whether right or wrong though short sellers are often accused of market manipulation during times of market turmoil and threatened with all kinds of reprisal, despite the counter claim that they’re simply keeping markets and companies honest.

A 2010 study by Jonathan Karpoff and Xiaoxia Lou found that short sellers are proficient at identifying financial misrepresentation before it becomes public and help to dampen market over enthusiasm.

Still, as one short seller put it: “I feel like we are the good guys, but when the media attention is on us it is kind of a lonely vocation.”

“I don’t think it (short-selling) is malicious,” says Martin Sklar, an attorney representing hedge funds. “It’s just people acting in their self-interest which is what Wall Street does.”

Nevertheless, when a small number of market players is making money they’re bound to raise the ire of the large number that is losing money; the latter seldom bothering to understand what it involved, or the risk it entailed.

At some point short-sellers must buy-back the stock they’ve already sold. That means they’ve not only bet on what that stock is worth, but on what they think the market won’t be willing to pay for it in the future. And as several edge funds found to their chagrin in recent weeks there’s no telling what that might be. It can certainly go well beyond the validity of the negative investment thesis. And all too quick if one of the bigger players needs to cover their position.

“If you are a short seller you are constantly being told that you are wrong,” says Jim Chanos, founder of Kynikos Associates. “Not everyone has the ability to drown that out. Most human beings perform best in an environment of positive reinforcement. We like to be told we are smart, we’re on the right track, we’re doing the right thing, and that the stocks we bought are cheap and are going up and that their earnings are going up as well… Wall Street is a giant positive reinforcement machine. That’s why it exists. If you’re a short seller, you’re coming in every day, and out of fifty names in your portfolio, you can count on ten names where there will be some noise. Stocks recommended, re-recommended, earnings estimates raised, CEO on CNBC; whatever it is, you’d be facing that noise. And, a lot of very good value managers completely break down when confronted with the fact they have to invest against the grain in front of all that noise. The best short sellers I know have an innate ability to drown out the noise – to not let it affect them.”

“Even when virtually assured an eventual profit,” says Rob Arnott at Research Associates, “short sellers risk losing everything in the short run.” To illustrate the point, he relates what happened in the Zimbabwean stock market as the country’s currency crashed in 2008 and 2009. During the three months August–October 2008, the Zimbabwean dollar plunged from 10 to 1000 to the US dollar, a 100-fold collapse. The Zimbabwean stock market, however, remained unfazed, rising 500-fold in just eight weeks – an astounding 50-fold increase in US dollar terms. When hyperinflation went into overdrive, the stock market eventually fell 98% before it ceased to exist. “Suppose we could have sold the Zimbabwean market short,” says Arnott. “The strategy would seem to be a no-lose proposition. But even with the prescience of knowing the market was going to zero in three months, by selling short we would have lost 50 times our money, with high odds of bankruptcy, even though we were eventually proven correct!”

It’s the willingness to accept such an outcome – to be right yet lose significant money - that should put the success of short sellers beyond reproach.

As Charlie Munger put it: “It would be one of the most irritating experiences in the world to do a lot of work to uncover a fraud and then to have it go from X to 3X and have the crooks happily partying with your money while you’re meeting margin calls. Why would you want to go within hailing distance of that?”
 
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