Short Selling

Short Selling (updated 27 Feb 99)

'Going long' an investment asset means buying it in the expectation of a future price rise. 'Going short' is the opposite: selling something you do not own in the hope of buying it back more cheaply in the future. Now that financial markets have primacy over hard asset markets, shorting should in principle be as normal an investment strategy as going long - increasing liquidity, driving down overpriced stocks and generally improving market efficiency (see MARKET EFFICIENCY). But as a percentage of the total market, short selling remains small: for example, in 1997, shorting activity was only 1.3% of the New York Stock Exchange (NYSE).

To sell stocks short, investors need to borrow them from willing lenders via a broker. This involves putting up 50% of the short sale price as cash collateral, paying a small fee for the borrowing privilege plus any dividends paid on the stock while the position is open, and setting up a supply of credit, also at some cost. These procedures tend to make shorting more difficult than holding a security long.

Short selling also exposes the practitioner to considerable risk of loss: when you go long, your loss is limited to what you paid for the stock; but when you go short, your losses are potentially without limit as the price at which you can buy back rises ever higher above the price at which you sold. A further risk is that the lenders may recall their stock at any time. In less liquid markets, this creates the possibility of a 'short squeeze', where it is difficult to 'buy-in' at any price in order to 'cover' the short position.

Why sell short? The obvious answer is to profit from the impending decline of an overpriced stock, an overpriced industry or indeed, an overpriced market. One of the most famous shorting episodes was in 1992 when George Soros (see HEDGE FUNDS) sold vast numbers of British pounds prior to sterling's collapse against the other European currencies to which it had been pegged.

Shorting can also provide efficient diversification as well as potentially earning a higher return on cash collateral: your cash continues to earn but you are also making money from the short sale proceeds plus, if you can negotiate it, a share of the interest the broker is saving by using your collateral rather than borrowing from the bank. (However, short sellers, particularly individual investors, do not usually receive the full sale proceeds, though institutions can negotiate to receive some of the proceeds or interest on the proceeds while the short position is open.)

But most short sellers will be investment brokers and bankers hedging other positions: for example, protecting long positions from a market decline with an offsetting short position; or hedging positions that may be quite different from the short position but which are related by covariance. Risk management has become increasingly popular in recent years, even after the disrepute caused by its failure in the late summer of 1998 - and shorting is a prime tool in the risk manager's kit.

Shorting gurus: Steve Leuthold and Kathryn Staley

Short selling tends to be counter-intuitive to most investors and, as a result, only a few sophisticated money managers and knowledgeable individuals use it as an active investment strategy (as opposed to a hedging technique). These professional short sellers look for companies with inflated reputations and prices, digging out unfavorable corporate information using a variety of techniques. One such is Steve Leuthold who works out of Minneapolis.

Leuthold employs a program called AdvantHedge, which he describes as 'a disciplined quantitative short selling program that is entirely focused on large cap liquid stocks'. This means that short sale candidates must trade in excess of $1 million per day and have a market cap of $1 billion - a universe of about one thousand one hundred stocks. The focus on liquid stocks avoids the problems of 'short squeezes' and low trading volumes, which can make covering difficult.

The stocks sold short by the program are selected by a proprietary 'Vulnerability Index' based on such indicators as industry group relative strength and fundamentals, performance rating, volume accumulation, insider buying and selling, and earnings disappointments; and including an array of triggers ('short covering disciplines') to cover, monitor and reduce short positions. The program can be used as a means to offset some market risk without dislodging long-term portfolio holdings; as the short side of a 'market neutral' strategy; or in a significant market rally, as an aggressive shorting tool. AdvantHedge is always 100% short in about fifty different issues.

Leuthold is a student of markets, writes volumes on every aspect of market history and its relationship to the current times. To maintain a distance from the daily market din, he takes frequent, short leaves to concentrate on major trends. And, among fellow professionals, he is regarded as one of the most all-encompassing of market strategists (see TECHNICAL ANALYSIS).

Another noted short seller of US equities is Kathryn Staley. In her book The Art of Short Selling, she lays out the four clues she looks for when trying to identify short sale candidates:

· Accounting gimmickry: clues that the financial statements do not reflect the true state of the company's health, with overvalued assets and an ugly balance sheet.

· Insider sleaze: signs that insiders consider the company a personal bank or are in the process of selling their stock.

· A gluttonous appetite for cash.

· Fad or bubble stock pricing, usually marked by a stellar price rise over a short period.

Staley's methodology can also be applied in the emerging markets simply by substituting the word 'country' for 'company'. In the dramatic market falls of 1997-8, some emerging market investments were sold off for the very same reason that certain US stocks get dumped: investors discovered that they were shoddily, even fraudulently, run.

Staley also points to what is often the main problem with short selling: being right but too soon. While a company may be overvalued, it may take longer than you expect for its price to fall and, in the meantime, you are vulnerable to margin calls if the price rises as well as the possibility of 'buy-in' if the lender wants the stock back. As an old Wall Street rhyme says, 'He who sells what isn't his'n/Buys it back or goes to prison.'

Counterpoint

Despite its contribution to market liquidity and efficiency, short selling still has a vaguely disreputable image. Many observers consider it to be 'betting against the team', an unsporting or even 'un-American' approach to investment, which can lead to severe market downturns. For example, it has been alleged that short selling contributed to the 1987 market crash as part of index arbitrage and portfolio insurance, although the use of derivative securities in such strategies seems to have been far more to blame (see RISK MANAGEMENT). And Malaysian prime minister Mahathir Mohamad wanted to make shorting illegal after the 1997-8 collapse of his country's currency and stock market, which he blamed on short sellers.

Part of the US regulatory response to the 1987 crash was the introduction of 'circuit breakers' as an attempt to slow downward market movements. These include the SEC's uptick rule, which insists that for a short sale to be implemented on the NYSE or the NASDAQ, the most recent price move must have been up. Such tight rules add to the greater costs of shorting than of regular sales or purchases. And these costs have the effect of inhibiting traders with unfavorable information, giving markets an upward bias.

The growth of indexing also increases the costs and dangers of short selling (see INDEXING). If you short prominent stocks in an index like the S&P 500 because their fundamentals are clearly slipping, you run the risk of losing out if the market rises dramatically since the questionable stocks will be swept along in the overall market fervor. But if you short stocks not in the S&P, there is no liquidity. For this reason, rather than shorting, it might be preferable to buy put options or sell stock if you think the market is near its peak.

Guru response

Steve Leuthold comments: 'The stock market's exceptional rise in recent years has given birth to the concept that we are in a new era of investing, perhaps with the implication that shorting equities in these circumstances is a mistake. But such thinking is just an attempt to rationalize a mania. So I offer some tongue-in-cheek 'new definitions for a new era':

· Bear market: when stocks decline for a week.

· Major correction: when stocks decline for a day.

· Old-timer: a person who knows someone who lost money in the stock market.

· Cynic: anyone reminding you stocks can go down.

· Conservative: anyone without a margin account.

· Diversified portfolio: any portfolio with less than 50% of its assets in technology stocks.

· Risk: how much you can lose being out of the market.

· Inflation: historical phenomenon that used to adversely affect stocks.

· Dividend yield: outdated concept once used in valuing stocks.'

Leuthold adds: 'Few of today's portfolio managers know much about short selling. In what has come to be seen as a permanent bull market, equity shorts and hedging have come to be viewed as unnecessary. Of course, old timers feel the laws of stock market and economic cyclicality have only been suspended, not revoked. I would say that the keys to our relative success shorting stocks in the biggest bull market of all time are the covering disciplines that we rigidly maintain.'

Where next?

After a long bull market, shorting is tempting, particularly when the market shows all the cultural signs of being in a form where there is universal enthusiasm on the upside, and double digit forecasts are common in the face of news that appears to be worsening.

And yet shorting takes a different mentality than most of us have. We are almost all products of a period in which markets have gone up for more than several decades. Shorting requires a certain form of tough-minded pessimism. And as indicated above, shorting produces the possibility of infinite loss: you can lose more than you put up, with the potential that the sky is the limit.

So unless one is really psychologically conditioned to this and unless the market has given definite indications that it is in a long downward trend, shorting is probably best left to the absolute pros and the people with daily attention.

At the same time, shorting means you no longer have to have an optimistic outlook, and thus has understandable attractions for people with a contrarian turn of mind or a 'gloom and doom' view of the world (see CONTRARIAN INVESTING). While many institutional managers, such as mutual funds, cannot go short, for those who can, it is just possible that it will be the investment skill that keeps them from financial disaster in a bear market.

Read on

In print

Steve Leuthold, The Myths of Inflation and Investing
Steve Leuthold's Perception for the Professional - a regular publication of the Leuthold Group
Michael Murphy's The Overpriced Stock Service - a short selling investment advisory newsletter from Murphy's company, Negative Beta Associates
Kathryn Staley The Art of Short Selling

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