Monday, February 18, 2013

Stock Market: Short Sellers Are Losers

The rally on the stock market doesn´t find much love. Quite contrary, you could hear a lot of lamentation. Many commenters are complaining that the stocks are already overpriced, that they have reached a new peak and must go down and that the fundamentals don´t justify the rally.

I suppose a lot of those allegations are made up by the so called short sellers. Those persons are betting on falling prices of stocks or other assets by short selling or "shorting" them (wikipedia). For instance someone takes a wager that the recent fall of Apple on the stock market will continue. She could borrow say 100 Apple stocks from the broker and sell them immediately. On Friday she would have got $ 46,016 in return (minus fees). If the short seller has luck Apple may fall to $300. She could now buy back Apple on the stock market, paying just $30,000 (plus fees) and return the shares to the broker. In this case the short seller would earn the difference from both transactions ($ 16,000 minus the fee for the broker and the transaction costs). But:  If the short seller has bad luck the Apple stock will rise, for example to $600. Now she has to spend $ 60,000 to be able to give the borrowed stocks back to the broker.

In the long run "shorting" stocks doesn´t pay. Since its start in the year 1896 the Dow Jones (an indicator for the whole stock market) climbed on average around 7% annually. This makes an average plus of around 0.02% a day. Yes, this is a marginal number, but any plus is a loss for the short seller and even stagnating prices lead to a loss because of the fees and the transaction costs. Hence the short seller is betting against the long term trend of rising stock prices.

Of course short sellers can make huge gains in special situations, like the recession years 2000-2002 and 2007-2009, or when the value of a company is shrinking against the trend. In both cases a short seller must have a lot of luck. She has to sell close to the beginning of a falling stock market and to buy the stocks back before the stock market has recovered. Or she has to find companies that are  falling out of fashion like BlackBerry (the former Research In Motion).

Self-fulfilling prophecies?

It seems that some of the short sellers are helping their luck  by spreading gossips about the companies they are betting against. That is easy, if your are a hedge fund manager with a huge reputation and billions of Dollars in your war chest.

The New York Times writes that there is a cult around some short sellers:

"There is a culture of worship around a small circle of hedge fund deities like Mr. Einhorn, John A. Paulson of Paulson & Company and even Steven A. Cohen at a somewhat tarnished SAC Capital Advisors. When one of them says or does something, it quickly reverberates in the market" (nytimes)

Hence stocks are often falling (at least temporary) just because one celebrated hedge fund managers says so, especially if this person has many followers who believe her blindly. In this case the short seller could easily damage the trust in the company she attacks which causes others to sell those stocks too. This herding behavior could induce a sharp drop of the stock price which further undermines trust into the attacked company. Maybe Lehman Brothers was brought down by a herd of short sellers who all were betting that this bank would go bust, causing a self-fulfilling prophecy (wikipedia).

It seems that the short sellers benefitted a lot from the gloomy & paranoid sentiment which followed the stock crashes from 2002 and 2008. Maybe they even aggravated the paranoid ambience for some time.

But it seems that for now often short sellers are facing some headwinds caused by the healing global economy and the stock market rally which started in spring 2009.

Stalingrad for hedge funds?

These days we can spot an ongoing battle around Herbalife, a producer and seller of nutritional supplements ( Last year the hedge fund manager and notorious short seller William A. Ackman of Pershing Square Capital Management shorted stocks of the company and then started bad-mouthing the firm. Ackman accused them to administer "a pyramid scheme". He claims "that the company relies primarily on pushing products to its recruited sales staff for its profits, rather than sales to retail customers and outlets" (nytimes).

Ackman´s allegations in combination with his huge reputation - the cult -  caused a sharp drop of the stock price (temporary minus 38%), exactly as intended. But the short seller hit some resistance. Daniel S. Loeb, another hedge fund manager, disclosed that his investment firm Third Point had bought nearly nine million shares of Herbalife. He further called the short-seller’s thesis “preposterous" and claimed that the attacked company will not only survive, but thrive (nytimes).

In February the famous investor Carl Icahn also declared that he had taken a large stake in Herbalife (13%) and confronted the short seller allegations (money.cnn).

Acording to Barron`s "John Hempton of Bronte Capital, who also owns Herbalife stock, calls this battle `hedge-fund porn` and has characterized the struggle over Herbalife as ´the hedge-fund equivalent of Stalingrad`" (barrons).

Another notorious short seller, his name is Jim Chanos, seems also to experience some headwinds. He has been banging the "China will crash" drum for years and shorting China stocks ( This reminds me of Don Quichotte because China´s growth rate didn´t fall below 7.6% and is accelerating again (plus 7.9% in Q4 2012) and in December 2012 the stock market in Shanghai started a new rally.

It looks like that the ongoing rally on the stock market, which seems to be a return to the long term trend, is crushing people like Chanos and Ackman. This could even weaken the cult of the short sellers.

Short sellers are losers.

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