Oft-Maligned Short Sellers May Yet Have the Last Laugh
Some things you can just count on in life: the swallows returning to Capistrano, the marine layer over L.A. on a June morning . . . and that every time the stock market goes down in a big way, Wall Street will blame the “short sellers.”
The shorts--bearish traders who borrow stock and sell it, betting that the price is about to plunge--have been fingered repeatedly in recent months as some of last year’s star growth stocks have imploded: names like Centennial Technologies, Employee Solutions and Corporate Express.
For the elite fraternity of shorts, the idea that they caused these stocks to crash is both laughable and ironic.
Laughable because there are so few dedicated short sellers left today, after 6 1/2 years of a relentless bull market. (This, however, may be about to change; keep reading.)
Ironic because the people selling stocks like Centennial and Employee Solutions as they plummeted this year were almost certainly investors who had been bullish on the companies--until they suddenly discovered, to their horror, that there was less to the businesses than had appeared.
Short sellers were in those stocks, all right. But they had shorted them months ago, after what is typically painstaking research into the companies’ businesses. When that research says a stock is far overvalued relative to what the firm can earn--or even better, that a firm is an outright fraud--the shorts move in.
Certainly, the growing number of individual stock disasters this year is giving the shorts more to crow about than they’ve had in many years. It’s also putting more dollars in their pockets: When they’re right about a stock crumbling, they can make big money. If they short a stock at $30, for example, and it plunges to $10, they make $20 a share, or 67% on what they risked (less commissions).
Some short sellers, like Bill Fleckenstein of Fleckenstein Capital in Seattle, fervently believe the U.S. stock market is on the verge of a horrendous decline that will crush many of the arguably overvalued stocks that have so far defied short sellers.
“To me, it’s 1982 on the short side,” says Fleckenstein, referring to the year considered the true starting point of this bull market.
Still, one would hardly describe short sellers in 1997 as a formidable army capable of making their anti-market dreams come true.
Michael R. Long, whose Rockbridge Partners in Charlotte, N.C., has been tracking short sellers since 1987, has seen plenty come and go in this long bull market. The last two years in particular, he notes, have been brutal on anyone betting on lower stock prices.
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Long’s account-performance index of 35 short-selling firms, typically small boutique investment houses, has lost money in seven of the last 10 quarters, through year’s end.
And even though monthly reports of “short interest”--the number of shares borrowed, sold and not yet repaid--show record levels of shorting on the New York Stock Exchange and on Nasdaq, those figures are misleading.
Many short sales don’t specifically represent bets on lower prices, but rather are “hedges” put on by investors trying to protect profits already accumulated in stocks they own, Long notes. Similarly, short sales are used by traders who traffic in takeover stocks, simply to hedge their bets on transactions already announced and awaiting completion.
Nobody knows exactly how many investment firms are dedicated only to researching, identifying and shorting overvalued stocks, but at most they may command about $2 billion in capital, Long estimates--less than 1% of the sum of new cash that mutual fund buyers threw at the stock market last year alone.
As a lonely, misunderstood and generally maligned profession within the investment business, short selling has no equal. What could be more un-American than betting on lower stock prices?
The shorts, however, view their work quite differently. They see themselves as detectives, trying to discover among high-flying stocks those whose probable long-term performance won’t come close to matching the hype perpetrated by company management or Wall Street’s analyst community.
And after 6 1/2 years of mostly rising stock prices, many shorts believe they are about to get paid.
It’s not a coincidence, they say, that Centennial Technologies--the best-performing stock on the NYSE last year, up 447%--has collapsed this year amid allegations of fraudulent accounting.
Shorts like Long, Fleckenstein and David Tice, who manages the Prudent Bear mutual fund in Dallas, contend that the final years of this bull market have been dominated by extraordinary corporate financial engineering: making sure a company hits its earnings target each quarter, whatever it takes.
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Many corporate officers, Long notes, have spent much of their time talking about what they’re doing for their stock--and little time talking about their actual business. Now, with interest rates and labor costs rising, global competition intense and many companies having run out of ways to cut expenses, the shorts believe financial engineering has hit a wall. They expect far more disappointments among companies whose earnings growth was supposed to be the most robust.
The sharp declines this year in many of last year’s hot “momentum” stocks, Tice says, are occurring not because short sellers are hammering the stocks but because mutual fund managers are bailing out of overpriced stocks that the shorts sold many months ago. “Pyramid schemes always end, and this is a pyramid scheme,” Tice says of momentum investing.
Corporate managers hate the shorts, for obvious reasons. Managers often accuse short sellers of spreading lies about a company, to beat down the stock. And it’s true that some shorts have used such unseemly tactics over the years.
But so far this year many shorts haven’t had to do much but sit back and watch the fireworks from exploding stocks--and collect what they consider long-overdue profits.
