Spoiled Shorts and the 2013 Rally

 | Jan 07, 2014 | 6:48 AM EST  | Comments
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How much did short sellers have to do with the incredible moves higher that we saw in 2013? How much of last year's positive action came simply because the predicted earnings downside didn't pan out? I've been gripped by this issue because, if you peruse the charts for the last year, I think you will be befuddled about why whole cohorts roared, especially given that there was no real impetus for the moves. In fact, in many cases these stocks seemed to go up entirely because things didn't go as badly as people thought. That's the sign -- that of spoiled shorts -- that can lead to this kind of behavior.

Let's take the curious case of Norfolk Southern (NSC). Here's a railroad that had become a very reliable short holding because of the prospects of coal dropping precipitously quarter after quarter after quarter. Sometime near the end of the summer, however, the stock started creeping up. Right then and there, if I were looking for a short, I would have been laying it out. I would have bet that nothing had changed, and that the stock would just get hammered again after the next earnings report, as had been the case much of the time.

You could almost make out the footprints of the shorts as the stock inched from $73 to $79.

Then the rail reported the quarter and, lo and behold, coal had only dropped 2%. More important, coal had at last become a small enough factor that it didn't kibosh the quarter. Next thing you knew, $80 went to $90.

I am convinced that the only thing that really happened at Norfolk Southern was that the coal decline, which had gotten out of hand, was finally manageable, courtesy some very strong chemicals and metals numbers and a hefty dose of pre-quarter estimate cuts. Norfolk Southern was simply a spoiled short from then on in.

Or take the insurers -- ones like Genworth (GNW) or Radian (RDN) or Principal Financial (PFG) or Lincoln National (LNC). It wasn't that long ago when these companies were perceived to be on the ropes. Lincoln and Principal were supposed to be on the hook for bad investments that could cause the potential for gigantic write-offs. I remember hearing that both of these were toast.

Genworth and Radian, I believe, actually were toast because of all of the private mortgage-insurance obligations they had written as home prices had relentlessly declined.

What did the shorts not get right on these? Perhaps it's that the Federal Reserve's policies had precisely the impact that the Fed had wanted. Those policies aimed to make it so that the Principal and Lincoln annuities and investments would come back to life, and the plummeting home prices -- which were decimating Genworth and Radian -- were to reverse course and roar back.

The success of the Fed is mind-boggling on these scores, particularly given that you heard over and over again that the various bond-buying programs weren't working. I wonder how many shorts got caught believing the ideologues who complained endlessly about the central bank's lack of efficacy. These shorts ran into a Ben Bernanke buzz saw, because one of the Fed chief's unstated goals was to save the likes of Principal and Lincoln and Genworth and Radian from going under. The shorts targeted the exact same thing that Bernanke targeted, and Bernanke won.

Then there were the short sellers I regard as having been too skeptical. All of the defense-stock short positions came under this category. These were simply intellectual shorts gone wrong. It was such an easy way to lose money, in retrospect. Even if we didn't see it coming, all of these companies had a real bead on the sequester, and they took action well ahead the ax man. Not only that, but these stocks had never been expensive to begin with, and the companies have always been huge cash generators. Shares simply failed to come down. In many ways, that was enough.

We saw many situations like these, in which the skepticism got out of control. The airlines, for example, had always been reliable short positions. Whenever their heads lifted, it was important to lay down as much short firepower as possible. But when these failed to disappoint, and when the Justice Department then gave the OK to the U.S. Airways-American Airlines (AAL) merger, there wasn't a short leg to stand on.

There are so many examples of this kind of behavior. The newspaper stocks had been reliable shorts until this year, when consolidations and vanity buyers stepped in and the remaining players simply turned up and stayed up. I remember recommending New York Times (NYT) and being laughed at by shorts who thought I had lost my mind. Nope, they lost their shirts. The refiners were supposed to be hammered because of a narrowing of the spread between West Texas Intermediate and Brent. Didn't happen. The disk-drive stocks were supposed to be bashed by giant new foundries pumping out drives. Nope. They weren't built. Hewlett-Packard (HPQ) was supposed to be destroyed by the anti-personal-computer tidal wave. Amazon (AMZN) was supposed to crunch Best Buy (BBY). Neither happened, and the stocks just couldn't stop rallying.

When we look back at 2013, we can say that it was the beginning of the economic expansion that was behind so much of the rally -- or that it was the Federal Reserve's low rates. But perhaps all that really happened was that the hedge funds that shorted for a living, and which had done so well even with the rallies off the bottom, capitulated. The result was a rally of insane proportions for many sectors, based on nothing more than a lack of degradation or minor reversals of fortune.

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