If you haven’t already, I strongly admonish you to go read Jesse Eisinger’s column today:

It’s a Tough Job, So Why Do They Do It?  The Backward Business of Short Selling

Here’s the money quote:

Short_interest
"The shorting life is nasty and brutish. It’s a wonder anyone does
it at all.

Shorts make a bet that a stock will sink, and nobody else wants
that: Not company executives, employees, investment banks nor most investors.
That’s why most manipulation is on the other side; fewer people object when
share prices are being pumped up. For most on Wall Street, the debate is whether
shorts are anti-American or merely un-American.

Yet in all the paranoia about evil short-sellers badmouthing
companies, what is lost is how agonizingly difficult their business is. They
borrow stock and sell it, hoping to replace the borrowed shares with cheaper
ones bought later so they can pocket the price difference as profit. It’s a
chronologically backward version of the typical long trade: sell high and then
buy low."

Go forth and read . . .

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Source:
It’s a Tough Job, So Why Do They Do It?
The Backward Business of Short
Selling

Jesse Eisinger
WSJ, March 1, 2006; Page C1
http://online.wsj.com/article/SB114118313441386192.html

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UPDATE March 2, 2006 10:32am: 

See below for more text

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LONG & SHORT By JESSE EISINGER   

It’s a Tough Job, So Why Do They Do It?
The Backward Business of Short Selling
March 1, 2006; Page C1

The shorting life is nasty and brutish. It’s a wonder anyone does it at all.

Shorts make a bet that a stock will sink, and nobody else wants that: Not company executives, employees, investment banks nor most investors. That’s why most manipulation is on the other side; fewer people object when share prices are being pumped up. For most on Wall Street, the debate is whether shorts are anti-American or merely un-American.

Yet in all the paranoia about evil short-sellers badmouthing companies, what is lost is how agonizingly difficult their business is. They borrow stock and sell it, hoping to replace the borrowed shares with cheaper ones bought later so they can pocket the price difference as profit. It’s a chronologically backward version of the typical long trade: sell high and then buy low.

Many hedge funds — the sophisticated investors who are the bogeymen du jour — try to avoid shorting. They simply can’t stomach the pain. Often, hedge funds only do it to be able to call themselves "hedge" funds — shorting is the classic way to hedge risk on long buys, after all — and charge those fat fees. Assets at hedge funds almost tripled in the past five years, yet short activity on the major exchanges hasn’t even doubled.

The biggest problem with the business is that the market is stacked against the technique. Stocks tend to go up over time. Shorts swim against this tide.

Under trading rules instituted after the 1929 crash, a short position can only be taken when the last trade was at the same price or higher, so they can’t drive down the price by selling and selling.

There is also theoretically no ceiling on potential profits from a long position. A stock bought at $10 can go to $20 for a 100% gain and then to $30 for a 200% gain. But 100% decline is as good as it gets for a short. The opposite is true, too: long losses are finite but short losses can be infinite. Many hedge funds have reduced their shorting for this reason. Why put so much time and energy into something that can inherently not pay off with a multiple bagger?

What’s more, shorting can be expensive when the shares available to borrow are scarce. Prime brokers, the investment-bank folks who facilitate hedge-fund trading, charge interest on popular shorts. Look at this week’s rates: It cost 25% to short Martha Stewart Living Omnimedia and 24% to borrow Overstock. So, you wouldn’t make a dime on the misery of Overstock CEO Patrick Byrne over the course of a year unless his shares tanked by almost a fourth of its value.

Given all that, how do the shorts fare? A study by Yale’s Roger Ibbotson and his eponymous research firm’s chief investment officer, Peng Chen, found that short-biased hedge funds fell 2.3% per year on a compounded basis after fees from 1995 through March 2004.

Sounds like a lousy business to me. So why bother?

The curious thing is those negative returns are actually quite impressive when you consider what shorts are supposed to do — hedge risk. The researchers calculated that the market, measured by the appropriate benchmarks, was up 5.9% a year in that period. That means short sellers started each year trying to climb out of a hole almost 6% deep. And, on average, they did, by 3.6%. That shows their stock-picking skill and ability to reduce market risks for clients, who presumably invested in those funds to hedge their long positions elsewhere.

Short-sellers obviously are in it for the money, but in talking to them for many years, I can tell you they are a quirky bunch who love ferreting out bad guys. The dirty secret of the SEC enforcement is that the major financial frauds are frequently uncovered by short-sellers. The shorts had Enron and Tyco in the cross hairs before anyone else.

Shorts aren’t always right. They shorted Sears, trumpeting its struggling retailing and troubled credit-card divisions. They shorted Amazon and eBay in the bubble years, failing to see that some Internet wonders wouldn’t go bankrupt. But it is a myth that shorts can easily profit from misinformation because the market is merciless in dealing with erroneous information.

Amid all of the targets’ litigiousness and outcry, short-sellers’ influence over the markets is vastly overstated. Here’s an example: Gradient, the independent stock-research firm being sued by Overstock and Biovail, started covering Overstock in June 2003 when its shares were traded around $13 and the company was expected to be profitable in 2005. Over the next year and a half, as short-sellers and Gradient bashed the company to anyone who would listen, the stock topped $76 a share. The company ended up losing $1.29 a share last year — yet the stock remains above $22, higher than where Gradient first picked it up. That’s some market-moving power.

Mr. Byrne, Overstock’s overlord, has been the most vocal in his assault against shorts and journalists who have shorts as sources, including me. But it isn’t the short-sellers who cause Overstock to lose money or to miss earnings estimates. It isn’t the shorts who screwed up Overstock’s information-technology installation. It isn’t the shorts who caused Overstock — just yesterday — to restate its financials going back to 2002.

By seeming to side with Overstock when it started seeking information about its complaints against the shorts, the SEC chills its best sources and hinders the market from doing its job. It was the shorts who lost money in Overstock for months and months — until most investors realized they were right.

Category: Data Analysis, Financial Press, Trading

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

14 Responses to “The Backward Business of Short Selling”

  1. miami says:

    As I told jjc:

    One wonders if the entire world will implode tomorrow. The doom and gloom scenarios are the worst I can ever recall, and seem to grow in proportion everyday. These days, one has to worry about virtually all facets of life, including, but not necessarily limited to, and in no particular order:

    The potential for derivative crises
    The bird flu
    The next hurricane season
    The Japanese demographic tsunami
    Low risk premiums
    Corporate profit margins at record levels
    Outsourcing
    Poor US performance in math and science
    Iranian nukes
    Iraq war
    Terrorism here and abroad
    The federal budget deficit
    The national debt
    High consumer debt
    The return of high inflation
    The housing bubble
    The credit bubble
    The oil bubble
    The commodities bubble
    The coming crisis in Social Security
    The US demographic tsunami
    Oil supply risk
    The bubble in San Francisco real estate
    Oil at $100/barrel, natural gas prices
    Global warming
    Globalization
    Outsourcing
    Rising long term rates
    Rising short term rates
    Falling US dollar
    Asset Inflation
    Asset Deflation
    The European demographic tsunami
    Consumer spending post-asset bubble
    Consumer spending if assets keep inflating
    Exogenous events
    Global imbalances
    Foreign surpluses
    US consumer stretched to the breaking point
    The bond carry trade bubble
    The unwinding of the Yen carry trade
    Overvalued US stocks
    The “house of cards” US financial system
    The condo bubble in Miami and Las Vegas and…
    The Chinese demographic tsunami
    The hollowing of US manufacturing
    India
    Ports owned by Arabs
    Reckless fiscal policy
    Wage stagnation
    The healthcare crisis
    The bankruptcy of GM and Ford
    Declining productivity
    The impending increase in volatility
    The yield curve inversion
    Negative US savings rate
    Corporate Malfeasance

    I am sure I missed a few – these are just off the top of my head of things I can’t seem to avoid reading about these days. Will someone please tell me some tiny shreds of good news so I won’t feel compelled to go 150% long?

  2. Bynocerus says:

    Here’s a thought: the NYSE was a whisker away from making another all time high today, yet only 5.5% of the NYSE made new highs today. The Nasdaq has a little more work to do, but its new high list was 5.5% as well. Meanwhile, Corning trades at the same P/E as Google on the strength of CRTs and catalytic converters. That’s what shorts are for (for good times, and bad times…)

  3. Miami:

    That’s a nice list of potentially dmaging issues; However, most of them are not exactly market related — at least not imminently.

    Here’s the good news:

    1) 14 Consec Qs of double digit growth.
    2) Record breaking Share buybacks.
    3) Enormous dividend increases.
    4) Huge M&A activity;
    5) Terrific IPO activity
    6) Most indices are at or near 52 week highs

    Note that while a handful of your issues are market related, ALL OF MINE are.

    You may pretend that all the news is bad, but sorry, that’s a straw man. Most of the market related news is positive.

  4. david price says:

    Hi Barry, I read you web site every day. Are you still sticking to a 2nd qtr downturn in the market potentially to DOW 6800?

  5. Bill says:

    Barry, it seems that you are watching the 4 Year Cycle and the Presidential Cycle based on your statements of the market. However, the Large Caps have not had a “bull market” and the BIX/RKH ( Bank) Indices are at all-time highs. We may escape the big correction that occurs in the 4th Year of a Bull Market

  6. Mark says:

    Barry-

    Enormous dividend increases? Where did that come from? What is the average dividend on the S&P? Two? Less than 2?

  7. pete Preissle says:

    Mark:

    BigCharts shows SPX yield today 1.7%.

  8. pete Preissle says:

    Barry:

    1. Tried following your admonition to read the article. WSJ says for subscribers only.

    2. What research can you point to that verifies record-breaking share buybacks is good news?

  9. brian says:

    1) 14 Consec Qs of double digit growth.
    2) Record breaking Share buybacks.
    3) Enormous dividend increases.
    4) Huge M&A activity;
    5) Terrific IPO activity
    6) Most indices are at or near 52 week highs

    7) Sale of pitchforks and torches reaches 5 year highs

  10. miami says:

    bynocerus, you seem to be ignoring the difference between the ‘maximum of the averages,’ and the ‘average of the maximums’ in your analysis, so to speak, they are not equal.

    The market can absolutely make new highs every month while only 5% of the individual stocks make new highs – that’s simple statistics. Just take the first 5% alphabetically, and say they make new highs. then they go flat and the next 5% make new highs, and so on. I would take 20 months for the initial stocks to reach new highs again, and the market would have gone up EVERY SINGLE MONTH in the interim.

    The market can and will go down, but not for the reason you cited.

  11. Bynocerus says:

    Miami,

    One of Barry’s most enjoyable articles of late involved Paul Desmond of Lowry’s. Mr. Desmond’s research highlighted the fact that as rallies advance, the number of stocks making new highs progressively narrows. In fact, at the peak in 2000, Mr. Lowry reported that only 6% of stocks were making new highs that days.

    About a week ago, the NYSE made a new high, along with 8% of stocks trading on the NYSE. The other day, that number was down to 5.5%. My point was simply that the rally has advanced to a place where the number of stocks participating is growing fewer and fewer. A new highs number @ 8.5% is a pretty good tell of how late we are in the rally.

    My post was short because the concept is pretty basic. Not trying to be a dick, but I’m not sure if I wasn’t being clear or if you just didn’t understand the concept.

  12. CDizzle says:

    I think that the consumer is still $2 out of every $3 of GDP, +/-. Although in places like my hometown (St. Louis), the local economy will grow .5-2% every year without exception, most of America (including St. Louis) has seen significant asset appreciation, most notably in the residential real estate market. Consumers, per my interpretation of the data, are borrowing against that newfound equity and SPENDING it. Also, per the data, the consumer is bumping his proverbial head against the value (not necessarily the equity but rather the increased/inflated VALUE, i.e. 100% HELOCS/mortgages) of his house. Wonder where the continued spending will come from? I assure you the people controlling his REAL wage don’t have the answer.

    This set of dynamics combined with rising short term rates, an inverted yield curve and reported near-return to historical averages in home foreclosures could well be the relative calm before the storm.

  13. todd says:

    shorting stocks is just more fun than going long. pure and simple. :)

  14. Abobtrader says:

    In terms of ethics I think shorting equities is just as ethical as buying. Bad practices and inefficiencies get reinforced if shares prices only drift up. For a fair price, you need buyers and sellers. If you only had the option of buying or not buying, this puts a bias in the system.

    That said, stock prices have an upward drift of between 5-10%, so shorting is going against the long term trend. I have shorted on rare occassion, but the balance of probabilities favours being long.

    In the bond market, those who are long are also betting on the dominance of economic bad news. These doom mongers benefit when wars break out, when employment numbers disappoint, and when people stop spending on the high street. Still, the country needs buyers of debt to function, and these people make money when bad things happen. Having and expressing a view in the financial market is what makes the system function – being a pessimist is just as valid as being an optimist.