Review & Outlook

Our take on the investing, financial, & economic themes of the day

When the Market is Falling, Why Not Sell Stocks Short?

13 October, 2014 by Ben O'Brien in Commentary

It might seem appealing to sell stocks short when the market pulls back as it has recently. If you could do it successfully, you could profit all the time, in good markets and bad. There are sophisticated hedge funds that try to do just this. Others use shorting as a way to hedge or lower risk. (That’s of course where the name hedge fund comes from, though the term has become largely a misnomer because most funds that use that label no longer actually do much hedging.)

There are many reasons , however, why shorting is not so simple and why we don’t do it at O’Brien Greene.

First of all, what exactly is shorting? Looking at how it works demonstrates some of the drawbacks of the process. When you sell a stock short, you are borrowing shares of the stock and then selling it in the hopes that the price will fall and you can buy it back at a lower price. The difference between the price you sold the borrowed stock for and the price at which you bought it back is your profit.

But who do you borrow the stock from? You have to find a brokerage firm willing to lend you the stock in order to sell it short. Shares are not always available to short, and when they are you have to make periodic interest payments the whole time you are borrowing the stock. If lots of people want to short a particular stock it may be more difficult and expensive to find shares available to short. Moreover, if the broker wants the shares back he can “call” the shares away at any time. You also have to pay the broker any dividends or interest earned during the holding period. All of this makes the whole process more risky.

Aside from the complexity and the fees though, shorting is especially risky because there is an unlimited downside. When you buy a stock the greatest risk you incur is that the company could go bankrupt and the stock could fall to zero, and you lose your whole investment. But you cannot lose any more than your original investment. However, when you short a stock, the stock could go up indefinitely. Even if you are convinced a stock will go down, the market can sometimes be irrational. As the old saying goes, the market can be irrational longer than you can stay solvent. Short selling is all about timing. You may be correct that a company is overvalued and the stock will fall, but unless you get the timing exactly right, it’s hard to make a profit.

The electric car company Tesla is a good example of the danger of shorting that Matthew has written about. The stock’s valuation became astronomical, and many people shorted it in 2013, but the stock only continued to rise, up 344% for the year. This year it just kept going and returned another 57%. As investor David Einhorn put it, “We have repeatedly noted that it is dangerous to short stocks that have disconnected from traditional valuation methods. After all, twice a silly price is not twice as silly; it’s still just silly.”

The CFA Institute blog also had a recent post that backed up this argument by looking at the returns of short hedge funds. The data indicated that short selling based on valuation is a highly unreliable strategy. According to the CFA blog, more successful short strategies tend to come from investors who short a stock after detecting fraud at the company.

Shorting can also lead to strange behavior in a stock. You might be convinced a stock will fall, but ironically, when lots of people short a stock that can lead a stock price to rise. How is this possible? There is a phenomenon called a short squeeze that happens when a heavily shorted stock unexpectedly goes up. The investors who are shorting it lose money and want to close out their short positions, and so they rush to buy the stock back. This rush of buying pushes the stock up even farther. Sometimes this leads a stock to shoot up dramatically.

I saw this happen in a medical stock called Illumina. The company looked very promising and had come up with groundbreaking genetic sequencing technology. Then a judge ruled that its technology could not be patented. This opened the company that had previously been the leader in this business up to vast new wave of potential competition. Short sellers jumped in and bought much of the outstanding stock. But then something funny happened. The performance of the company was still very good. The stock rose. Now the short sellers wanted to get out. They bought back their shares and all of a sudden the stock that had seemed to be doomed went on a huge rally. This phenomenon is not all that uncommon, and adds to the risk of shorting.

There are occasionally short sellers who are highly successful. In his book The Big Short, Michael Lewis profiled a handful of investors who managed to short various securities leading up to the financial crisis and profited enormously. The book is insightful and entertaining but hardly a guide for reliable investment strategies. Rather, these were high risk, once-in-a-lifetime investments that also involved a good bit of luck too. Some of the heroes of the book struggled when they tried to replicate the “big short” afterwards. Hedge fund manager Kyle Bass, for example, who Lewis portrays as a market savant went on to predict the downfall of Japan, just before the country’s tremendous rally in 2013. John Paulson, another of the heroes, had a terrible year when he bet on gold in 2011 after his post-financial crisis bonanza in 2009 and 2010.

After the financial crisis and Lewis’ book, shorting came into vogue for a bit. Lots of people were trying to predict and profit from the next crisis. Of course this was just in time for the Fed’s Quantitative Easing programs and a 200% rally in the market. Several short-selling hedge funds that were formed during this period ended up folding as the rally continued almost unabated for more than five years.

While we are not proponents of shorting stock in our clients portfolios, we do not go so far as to vilify short sellers as some commentators do. Though it is risky, there is usually nothing sinister about selling stocks short. In fact, short sellers in many ways provide a valuable service and make the market more efficient. Some short sellers are experts at calling attention to accounting fraud and other corporate malfeasance that might otherwise go undetected.

Once I was interested in a fast-growing online education stock called K12 Education. Then I read a devastating critique of the stock by prominent short seller Whitney Tilson who also happened to be an expert in education and served on the board of Teach for America. He argued that the company was cutting corners and doing students a disservice. When the company could not counter Tilson’s accusations, the stock plummeted. I was thankful for his diligence and expertise because prior to his critique, which proved to be accurate, the company’s rise appeared to be unstoppable. Short sellers provide a useful signal about a stock. A heavily shorted stock is often volatile and dangerous.

Recent history has confirmed our firm’s long time view that short selling is not a suitable strategy for our clients. Shorting is often used as a kind of speculation or market timing. Holding high quality stocks with dividends and strong fundamentals tends to hold up better than the market during sell-off such as the one we’ve seen recently. While some successful short sellers exist, on average shorting amplifies risk dramatically while producing unreliable returns.