Time To Short The Market?

The six-year bull market is coming to an end, some say.

To profit from falling stocks, short investors borrow shares and sell them, believing the shares will be cheaper to buy back and return to lenders in the future. But when a short call is incorrect and the stock rises, the downside can be hard.

David Tepper, a billionaire investor, said during a recent CNBC interview that stocks are cheap at current levels — and shorting the market may not be the best strategy moving forward, according to benzinga.com.

Tepper’s view is based on developments in Washington. President Donald Trump’s administration has indicated it won’t be placing additional regulations on business which in itself is encouraging investors.

Tepper further noted that “every region of the world is growing” and that the growth is “synchronized.”

Concerns of a trade war with China have diminished, Tepper said. In addition, he is confident that the rhetoric flying between the U.S. and Mexico will subside.

Finally, Tepper argued that the Federal Reserve has signaled it will raise interest rates, a rising interest rate environment won’t impede growth.

A Bearish Market Isn’t Definite

Tepper is not the only pro to advise against betting on a bearish market.

The Standard & Poor’s 500 index through Friday had fallen 8.6% from its peak, far short of the minimum 20% fall to be considered a bear market, according to The Los Angeles Times.

Bearish signs do exist. Global economic fears, rising interest rates and weak corporate earnings affect stocks. But if a bear market is coming, there’s no reason yet to act.

Individual stocks in heavy machinery, energy and biotech have fallen 20% from 2015 highs. But the losses are modest in the food, technology, home building and utility sectors. The typical mutual fund with a mix of U.S. big company stocks fell 7.5 in the third quarter and is down 6.5% to date, according to Morningstar.

Every stock sell-off does not bring a bear market. Since the bull market started in March 2009, the S&P 500 has seen seven declines of 7% or more, excluding the current slide, according to Yardeni Research.

The 2011 sell-off was the only one approaching bear market territory. The index fell 19.4% before it recovered.

How Long Can The Bull Market Last?

The current bull market is getting old by historic standards. That in itself is giving cause for expectation of a bear market. But according to James Stack, an InveTech Research money manager and market historian, it takes a fundamental factor like a recession or skyrocketing interest rates to kill a bull market.

Economic indicators still favor growth. The Conference Board’s leading economic index is positive. Consumer spending is still strong, as are car sales, and the economy is creating jobs.

The global economy is struggling, undermining profits. This has caused a devaluation of foreign currencies against the dollar, making harder for U.S. exporters to compete.
Devalued foreign currencies hurt profits that U.S. firms create abroad.

When China drove its currency down 2% against the dollar, that created fears of a Chinese slowdown, causing Chinese stocks to fall and bringing other markets down with them.

But U.S. stocks are not cheap according to standard measures. The market’s price-to-earnings ratio – stock prices divided by earnings per share, is positive for the S&P 500.

What To Look For Before Shorting

The Bank of America Merrill Lynch strategists, led by Michael Hartnett,
are waiting for signals in four key areas “before calling for The Big Short,” according to MarketWatch:

• unambiguous signs of bullish investor positioning
• similarly enthusiastic profit expectations
• hawkish policies from both the Fed and the European Central Bank
• outperformance by last year’s laggard risk assets, such as European stocks

Unlike buying a common stock, where it is possible to initiate a position and hold indefinitely, selling short requires watching the market closely since losses on a short position are theoretically unlimited.

Short selling, while potentially lucrative, is a highly specialized field. When a short call is incorrect and the stock rises, the downside can be great.

Jesse Lauriston Livermore reportedly made fortunes short selling stocks in both the 1907 and 1929 market crashes, but he ended up losing his fortune. It is believed he turned bullish prematurely and bought stocks before the market bottomed in the summer of 1932, according to Wikipedia.

How Have The Shorters Fared?

Shorting is a specialty, and even the specialists have not all fared well.

James Chanos’ $3 billion Kynikos Associates hedge fund firm is known for shorting stocks. In 2015, Chanos’s short-only fund called Ursus was up 10%, trouncing the S&P 500, according to Fortune.

But life has been hard for many short investors in recent years. The gains from 2009 to mid-2015 saddled many with big losses.

One dollar invested in Ursus at the beginning of 2007 would have been worth about 68 cents at the end of 2015, according to its investors. Those who didn’t get in until 2009—when the last bull market started—$1 would have fallen to about 38 cents.

David Einhorn, renowned for a timely short of Lehman Brothers in 2008, made a number of unsuccessful short bets since then—including against Chipotle and Green Mountain Coffee Roasters.

Kingsford Capital Management, a short-only firm, fell to about $250 million in assets in 2015 from $1.8 billion in 2008, according to its investors.

Not all the loss was from investing losses. Kingsford founder Mike Wilkins gave about $800 million back to investors at the end of 2008, judging it would have been hard to find shorts following that year’s bear market. The firm finally broke its losing streak in 2015, registering a 5% gain.

For most money managers, shorting serves as a hedge against losses elsewhere in their portfolios.

Greater scale can allow short specialists to draw institutional investors looking for a hedge. This is one reason Chanos has been able to remain in the game since the early 1980s. He diversifies with around 50 short positions at any given time.

While broad-based short-biased hedge funds have fallen, an uptick has emerged in managers making public short bets.

Short sellers do extensive and costly research. Their losses can add up fast if a short seller doesn’t have the capital to wait it out.

Besides Chanos, few of the well-known “activist shorts” are mainly short-sellers.

GeoInvesting and Muddy Waters, research firms that earned credibility exposing Chinese stock frauds, started hedge funds that channel analysis into short bets.

Shorting the market can pay big, but whether now is the right time is a hard call to make.

Images from Shutterstock.

Lester Coleman is a veteran business journalist based in the United States. He has covered the payments industry for several years and is available for writing assignments.