Short Sellers Have Reason to Smile--a Sliding Market
Short sellers don’t expect to be loved for bad-mouthing popular stocks, but they do demand a little respect--and a profit every once in a while when they’re right about an issue being grossly overvalued.
So far this year, the shorts finally are getting their due. After enduring huge losses in 1991 when bad and good stocks alike just kept rocketing, professional short sellers have racked up tidy gains since February as many stocks have plummeted.
To sell “short” is to borrow stock from a brokerage and sell it in the open market. The bet is that the price will plunge, allowing the trader to repay the loan later with shares purchased at the new, lower price. If you sell a stock short at $50, for example, and the price falls to $40, your profit is $10, minus transaction costs.
Conversations with half a dozen short sellers nationwide indicate that most have earned 6% to 10% in their accounts so far in 1992. In contrast, broad stock indexes are down 1.5% or more. Tuesday’s market slide added to the shorts’ profits.
More ominous for market bulls, the shorts believe stocks have only begun to correct the wild excesses of 1991 when many issues--led by the now-infamous biotechnology shares--soared to dizzying heights on trumped-up expectations.
“I think there’s some very significant downside ahead,” argues Robert Doedde, a short seller at Centurion Trust Co. in San Diego.
Wishful thinking? Maybe not. The key, say the shorts, is that rationality has returned to the market, after a long and puzzling vacation.
Most short sellers make a living by performing very thorough research, looking for companies that have no reasonable chance of meeting the expectations built into the stock price. In last year’s wild bull market, the shorts targeted plenty of stocks that they believed were significantly overvalued. The surprise was that those stocks became much more overvalued as the year wore on, despite the shorts’ best arguments.
Result: The average short seller’s account lost an astounding 30% last year, according to short-tracker Michael Long of Rockbridge Partners in Charlotte, N.C. In short selling, the numbers can get messy in a hurry. If you short a stock at $20 and it soars to $40, you’ve lost 100%. If it keeps rising, your loss is potentially limitless until you buy it back and close the position.
The painful lesson relearned by the short fraternity in 1991, Long says, was simply that cycles of baseless investor enthusiasm can run much longer than logic would dictate.
Even so, no hot-air balloon rises forever. In February of this year, many of the most overvalued sectors of the market finally began to deflate--starting with biotech, then spreading to restaurants, drug companies, brokerages, home builders and a host of other industries.
But with a long list of formerly hot stocks now off 30% or more from their winter highs, why haven’t the shorts done better than 6% to 10% gains? While instinct told veteran shorts in January that growth stocks (such as biotech) had finally zoomed to Dream Land, many traders lost so much betting against those issues in 1991 that they were too skittish or too poor to try again.
Now that last year’s market leaders have cracked, however, the shorts smell blood. Most don’t predict a market meltdown, but rather just deeper declines for the most overvalued stocks.
Thus, the shorts are focusing on the traditional home of high-fliers: the NASDAQ market of mostly small stocks. NASDAQ shares shorted totaled a record 388 million in May; in contrast, NYSE short sales remain below previous peaks.
Jon Merriman, whose Beverly Hills-based Curhan, Merriman Capital Management is an active short seller, believes many hard-hit smaller stocks have farther to fall. He is particularly bearish on the faddish restaurant group, including Buffets Inc. ($29.25 Tuesday on NASDAQ) and Lone Star Steakhouse ($22.25, NASDAQ).
Even after their spring plunge, many restaurant issues trade for 30 or more times estimated 1992 earnings per share, Merriman notes--nearly double the average stock’s multiple. Investors obviously are forgetting how quickly restaurant themes come and go, Merriman argues. Making a steak isn’t brain surgery, he says, but the stocks’ prices still suggest otherwise.
