In Defense of Short Selling

 | Apr 02, 2012 | 12:00 PM EDT  | Comments
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This commentary originally appeared at 8:02 a.m. EDT on April 2 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

What passes for sound doctrine in twenty-first-century central banking -- so-called financial repression, interest-rate manipulation, stock-price levitation and money printing under the frosted-glass term "quantitative easing" -- presents us at Grant's with a nearly endless supply of good copy.

-- Jim Grant

With the S&P 500 advancing by nearly 27% since the October bottom, it seems almost silly to defend the role of short selling, but I will do just that this morning.

Over the years, I have rejected consensus and orthodoxy in favor of the logic of argument and power of dissection. At times, this approach puts me at odds with consensus, as I am often bullish when others are bearish and bearish when others are bullish, since the keystone to my market views is that there is little permanent truth in the markets.

Sometimes I get it right -- sometimes wrong.

Markets are invariably moved by the unexpected or what the crowd is not anticipating. Part of my job, as I see it, is to game whether the crowd is wrong or should be faded -- or as legendary hedge fund manager Michael Steinhardt once said, to develop a variant view.

As we all know, this objective is easy to talk about, but hard to put into practice. Over the course of time, this pursuit has led me to specialize in selling short, and at times I have maintained sizeable short positions (even as stock markets advanced).

It appears the basic objections to short selling are that:

  • when economies stumble, public policy (fiscal and monetary) comes to the fore and defends against an acceleration of economic and corporate profit weakness and often inhibits natural price discovery;
  • risk and reward are asymmetric in short selling;
  • the historic average annual positive return for equities is an insurmountable headwind; and
  • the exercise of selling short is analytically time-consuming -- long ideas are dished out on a silver platter by Wall Street, not true of shorts.

I couldn't disagree more. Financial concepts have their seasons, and the market's numerous dives over the past decade suggest, once again, that a great deal of money can be made on the short side and that we should revisit the case for short selling.

Sometimes a market gets terribly overvalued -- as it did in the late 1990s, when investors adopted the DJIA 36,000 notion (i.e., that there shouldn't be a risk premium on stocks) or embraced the notion of a new paradigm (i.e., an uninterrupted economic boom) -- which creates a generational opportunity on the short side.

Other times (more often than the above condition) individual securities or sectors are embraced by market participants and levitated to unimaginable valuations, which also creates an opportunity on the short side.

Mainly, it seems to me that opportunities to challenge biases are much more pronounced and more easily identifiable on the short side, no matter what the market conditions are. If for no other reason, this is because so few are comfortable with the short side, which makes for an inefficient market.

People want to look on the bright side. Individual and institutional investors and the management teams of corporations are invariably biased and bullish. How else to explain that nearly every money manager interviewed in the media is constructive? As well, consider whether you have ever witnessed an interview with a corporate executive who was bearish on the future of his company. In my numerous appearances on CNBC's "Squawk Box," I have never encountered such an animal. When is the last time you saw a downbeat CEO on Jim "El Capitan" Cramer's "Mad Money"? (These are some of the reasons why I never visit corporate managers in assessing a company's outlook.)

Warren Buffett put this more eloquently in his description of corporate truth telling in a letter to Berkshire Hathaway (BRK.A/BRK.B) shareholders in the late 1980s. In explaining his absence of an interface with management, he wrote that "corporate managers lie like ministers of finance on the eve of devaluation."

As always, Buffett was ahead of the times.

That said, poor management, frauds and eroding company or industry trends always will be in fashion, regardless of market conditions. This occurs despite the appearance of short selling as a "mug's game" or losing proposition based on the headwind of longer-term trends in equity returns.

Finally, more than any time in history, it can be argued that the secular headwinds (fiscal imbalances, structural unemployment, technological innovation, globalization, etc.) to worldwide economic growth around the world and the multiyear process of deleveraging from the last cycle represent powerful gusts that challenge a smooth and self-sustaining growth trajectory.

These factors (and others) are likely to lead to a more tentative and inconsistent backdrop in which corporate managers will likely find it more difficult (than in the past) to navigate the currents.

In summary, short selling and hedging seem to me to be a necessity in an increasingly uncertain world (and in our new normal), especially in this more trying economic period that has followed the bubble's piercing. After all, farmers do it, oil exploration companies do it, miners do it, even property owners do it by selling forward with long-term leases.

Moreover, short selling creates portfolio stability and a hedge against the inherently positive bias of analysts, managements and even human nature. Rather than being a mug's game, I have concluded that short selling is a useful tool that can provide profits in almost any market setting.

From my perch, the construction of a short is almost as important as the short itself, especially given the asymmetric risk/reward, which provides investors with an opportunity to capitalize on short-selling opportunities with some degree of comfort. This can be accomplished by buying puts or, as I like to do, through purchasing out-of-the-money calls as protection against the short. This also serves to buy time for the short catalysts to develop.

Given that there is little permanent truth in the markets, I have concluded that short selling is a necessary part of an investor's repertoire -- or at least mine.

_______

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