Short Selling: Lies, Damned Lies, and Statistics

The Financial Times and the New York Times (coincidentally?) featured two articles yesterday, where both writers lament over the apparent loneliness/dearth of short sellers:

  • Shorters Needed by Dan McCrum (Financial Times)- “Dedicated short sellers are a rare breed which has become even rarer in the last five years.”
  • The Loneliness of the Short-Seller by Alexandra Stevenson (New York Times) - “Now, six years into a bull market run, with stocks in the United States smashing one record after another, these naysayers have all but lost their voice.” The title of this piece sounds more like a ballad about unrequited love then about financial markets.

While the primary assertions found in both articles are largely true (both authors did a fine job, despite poor data) - yes, dedicated short sellers have become rarer in recent years - one of the sources they cite is (at best) misleading/inaccurate/incomplete:

HFR Hedge Fund Industry Estimates, from FT

Rather than rigorously proving why (via an academic paper), here are two reasons the above “data” is (disturbingly) problematic:

  • Red Flag #1 - See 2012, 2013, and 2012 to 2013 y-o-y changes, per table above. Compare against what happened in the markets.
  • Red Flag #2 - Compare against the Barclay Hedge data

Additional Comments:

  • History Rhymes - Since 2013, I have been telling/warning some people that perhaps we are living through a period (for short-sellers) that resembles the 1990-1995 period… a period of (similarly) abysmal aggregate short-dedicated performance. And this period came immediately after the 1980s, a period where dedicated shorts were able to return 20-60% annualized returns, even in a rising market environment!
  • Structural Changes over the years - Hedge fund AUM is at all-time highs…and with that, there are significant dedicated short exposure unaccounted for by these ‘check the box’ data series. There are some large and very large hedge funds, not classified as “short-dedicated” with short-dedicated exposure. There are also these mutual fund “Long Short” vehicles and short “ETFs”. Both types of vehicles seem highly pathetic. And then there are the quantitative strategies.
  • The Real Bubble - The real bubble is not in equities - it’s in GOVERNMENT BONDS. Supposing I’m correct, the intellectual (and knee-jerk) temptation is to say that everything else declines, as government bond prices decline. Yet I don’t see this as an inevitability. Capital / marginal capital tends to have pro-cyclical tendencies, i.e. it flees what’s not working, and joins what is working…
  • Inflection Point 2015 (?) - 2014 and 2015 (so far) validated my theory I feared in 2013 (that short-dedicates were experiencing a period that resembled the early 90s)… that being said, I believe we are now at a critical inflection point. I believe that the prevailing patterns in coming years will not resemble the 2006-2008 period. Rather, we will probably start seeing market activity that more resembles that which occurred 50-150 years ago. The suppressed volatility - the hidden build-up of volatility over the last few years - will (finally) lead to some “inhuman volatility” in coming years (starting this 2nd half of 2015) in asset classes that have thus far been immune. The volatility observed in certain key currencies (e.g. euro, yen, USD) since 2013 has started percolating into the government bond markets… a friend of mine says “equity is always the last to know”. I don’t think this rise in volatility is to be interpreted as necessarily ‘bearish’ for equities. I think it’s going to get far more complicated than that in coming years, and starting very soon.

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