It's a great time for bears and the favorite strategy of those who think the sky is falling.
That strategy, of course, is short selling, which is achieving near record popularity as investors look for ways to escape a brutal S&P 500. That has been dropping at an annual rate of 20 percent. So it should come as no surprise that shares shorted on the Big Board and the Nasdaq have been at near record numbers.
This aggressive gamble on a declining price, which calls for a stock to be borrowed, has been a tremendously effective strategy over the last few years. Indeed, the average short selling fund was up about 30 percent through most of last year.
How did bears get so much honey? The profit is the difference between the price at the time the stock is shorted and when it is covered, or repurchased. And it is this strategy that traders say has fuelled some periodic rallies in the market. Because of the high risk, most shorts are arbitrage-driven.
Attracting Money
Still, there is debate about shorting. Is it starting to appeal to the average investor or is this extreme strategy just attracting more money? Market observers disagree on this point. But one trend over the past few years is that short interest in stocks has risen fairly dramatically. That's according to Mike Schurmann, a senior analyst at the Leuthold Group, a Minneapolis investment manager that has various short selling accounts for pension and trust funds. In part this rise in short interest means that the knives are out for more stocks. Nonetheless, it doesn't make short selling a safer proposition, even with a stock that has many short sellers.
"With high short interest, you can have a double momentum of the stock price moving in a positive manner based on its own fundamentals and then, on the trading side, because short sellers need to get out of positions," said Schurmann. "And it snowballs." Recently this has tended to occur in the telecom, wireless telecom and airline sectors-industries that make big negative news. That kind of news attracts short sellers.
For an investor who wants to put on a short, one of the keys is actually finding the shares to borrow. A long/short hedge fund manager in New York, who did not want to be named, points out that it's almost never difficult to borrow a stock to short, unless it's United Air Lines (NYSE: UAL) or another stock in similarly dire financial straits. UAL stock, he says, couldn't be borrowed for the last year.
There are now online stock-lending platforms such as EquiLend and the smaller SecFinEx. But for most short sellers the best solution is having a good prime broker or two. The most effective brokers have a large stock of securities or solid connections that enable them to call around and locate the securities sought.
Selecting the stocks to short depends on the kind of fund a manager is running. When the same long/short hedge fund manager in New York looks for a short as a hedge against one of his longs, he typically looks for something in the same industry with similar trading characteristics and a similar fundamental profile. Alternately, he might engage in a capitalization arbitrage. That's when he goes long shares in the capital structure of a company and short shares somewhere else in the capital structure of the same company. For example, that happens if there's an A class and a B class of shares.
Different Approach
Leuthold Group and other fundamental short sellers take a different approach. The Minneapolis money manager, for instance, runs quantitative statistics on a universe of 1,100 stocks and comes up with the 50 most vulnerable names. It shorts hundreds of thousands of shares in a stock at a time. But it reduces its risk by diversifying its positions and maintaining maximum portfolio percentages in broad sectors.
The firm also stays away from stocks whose average daily trading volume over the previous month was less than $5 million, or whose short interest ratio is five or greater. The short interest ratio is the short interest divided by the previous month's average daily trading volume. That figure, critical to short sellers, gives a rough indication of how many days it would take for all short sellers to cover their positions. A higher number means that it will be harder to cover the short if anything negative happens to the position.
A conservative short seller must also have clear covering disciplines, which dictate changes to short positions when certain trigger events occur.
"We don't try to ride shorts all the way down to the bottom," Schurmann said. "A lot of short sellers who are shorting one or two stocks at a time either expect big things to happen or sit on them for far too long. Having good covering disciplines is even more important than finding stocks to short." The firm's average holding period for positions is currently 15 weeks.
Short selling has traditionally been the purview of hedge funds, pension funds and institutional investors. Until 1997 mutual funds were effectively prohibited from shorting stocks. Jeff Keil, vice president of the global fiduciary review group at Lipper Inc., notes that more mutual funds are now able to short stocks. The option has been written into their charters. But are more of them short selling?
"Probably not," Keil said. Indeed, Schurmann contends that shorting is not becoming more popular. "But people are extending their views about how to diversify portfolios or the funds they manage, and short selling is a tiny part of that," according to Schurmann.
Nevertheless, a recent report by State Street Global Advisor's Chief Investment Strategist, Ned Riley, found record levels of shorting. But there's still a stigma against short selling in the mutual fund industry. In addition, "while upward trends are more easily identified, downward trends are more difficult to predict," Keil said. "Portfolio managers may be more inclined to use shorts as a hedge, but not as a fundamental philosophy or fundamental way to invest." For hedging purposes, Keil adds, ETFs are a primary venue since shorting a sector mitigates some of the risk associated with a company-centric play.
Meanwhile, the issue of short selling's bad reputation remains relevant. The Astec Group, a New York investment consultancy, examined securities lending and borrowing data over the last few years in an effort to infer short-selling patterns. The firm also ran correlations to market prices to prove or disprove the argument that short selling is bad for the market system.
Securities Lending
The Astec Group concluded, however, that short selling is essentially good for the markets. The most striking finding, said the firm's executive director Ed Blount, is that in the weeks following the 9/11 terrorist attack, short sellers were providing support for the market. That's what was suggested by the securities lending data from banks that worked with the consulting firm.
"The [short sellers] were returning securities loans en masse to banks and therefore had to be buying in order to make those returns," Blount said. "They were providing a kind of benevolent force at a time when they were accused of helping to push the market lower."
Not all trading pros will agree about the merits of short selling based on this data. Large pension funds were concerned about the PR impact of lending stocks to investors, or funds that were shorting the market, driving it down. And some considered terminating their lending programs, Blount says.
"You couldn't have the kind of shorting you have today without the supply being provided by institutional accounts," he said. This applies mainly to pension funds, he notes. That's even though over the last few years mutual funds have started to lend their securities portfolios to short sellers in ever-increasing quantities.
Short sellers, along with bears who sometimes kick up their heels as Wall Street crashes, are an integral part of the equities market.
