Being Skeptical of Skepticism: The Best Kept Secret of Short Selling

Introduction

This holiday weekend has given me the opportunity to be reflective/introspective of the last 10 years of my life. As a result, I feel the itch to write about a few specific topics that have been on my mind for the last 1-2 years.

I suspect this post will be most relevant to and best understood by those who possess the genetically defective “short seller gene”; probably applicable to bona fide contrarians as well. If a wider audiences finds this post useful, entertaining, etc. – all the more better.

The Best Kept Secret of Short Selling

I will get straight to the point: I believe the best kept secret of short selling is… to become skeptical of one’s (and others’) skepticism. It is to be doubtful of doubts. It is to harness this preternatural gift of short selling that is ordinarily used by the short seller to identify fraud/fads/failures (while others see nothing), and instead, use this gift to identify cases where one’s or others’ suspicions of fraud/fad/failure are misplaced… and climb walls of misplaced worry. The best kept secret of short selling is to go long, with a long-term orientation.

One of the most useful talents that short sellers tend to naturally exhibit: what might make for a bad, maybe terrible long investment. Short sellers, in theory, can do a far superior job versus the long only investor, of filtering out what NOT to invest in, waste time in (e.g. value traps).

I will posit that not only is this the best kept secret of short selling, it is actually critical + necessary for survival, for most people… otherwise, one risks experiencing crippling financial losses, career instability,  household turmoil, mental illness, and even, suicide.

Becoming comfortable with consensus and trend following

I have naturally contrarian tendencies (oddly enough, I avoid using the word ‘contrarian’ as I find many pretend contrarians who use the word dozens of times a day), but have found that the status quo is actually often correct: it pays to be with the consensus most of the time.

Without me knowing it, I started testing this ‘best kept secret’ in 2011… though meekly. While I have slowly become emboldened over time, I remain somewhat meek. My primary mistake has been selling longs prematurely: I probably felt that if the market was showing some validation of my position, I must sell. Yet the biggest money to be made would’ve been to hold on to longs, even as they became consensus positions – even ‘crowded’ positions – over the course of several years. I should have continued being skeptical of my own skepticism.

My best friend has jokingly said that if I sell a long position, it will double over the next 2 years. I bet that if I can learn the ability not only to hold onto a position as it becomes accepted by the mainstream – but to size up the position as it works in my favor – I’m inclined to believe that good things will be happening to me.

 

Complicating Factors and Important Context

  • Some might assert that the existence of this post itself would imply we are at a peak in risk asset prices, or in late stages.  I keep an open mind to that possibility…yet, these thoughts have been on my mind and put into practice for several years now.
  • My above thesis might sound fine and dandy in theory, but in practice, I’ve found that some people are just naturally inclined to buying stocks, while others are just inclined to shorting stocks (though the latter is a tiny minority). Habits/character are difficult (maybe impossible) to change.
  • I’ve seen some short sellers (and former short sellers) whose long books seem to be exclusively dedicated to short term short squeezes. They don’t have a fundamental view of the business nor do they care. In addition to some real ethical + legal questions, I think the bigger money is made in looking for long term longs.
  • It would be incredibly naive and intellectually arrogant to dismiss the possibility that my thesis is NOT shaped/coloured by an US-centric view of investing. A US-centric view of markets, blind to the experiences/history elsewhere, is dangerous. Macro matters.
  • I think if you take my thesis, that “The best kept secret of short selling is to go long, with a long-term orientation” to its natural limit, you approach global macro. I think global macro is the ultimate expression of this thesis.
  • In practice, it is often difficult to gauge what the sum total and incremental doubt/skepticisms are, embedded in current market prices.
  • As much I love to joke about it, I am not implying that short sellers should stop shorting stocks, and become long only investors. Far from it. The short sellers needs to continue practicing short selling precisely because the practice of short selling can make the short seller a competent – maybe even dangerously good – long investor.
  • It is said that “being contrarian is not sufficient – you must also be correct” – to which I would add this corollary: “Being skeptical of skepticism is not sufficient – you must also be correct”
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Buying the dip: slowly getting back into the pool

I’m currently feeling the same way I felt in mid January / early February 2016 about us equity markets: I’m a marginal buyer of US equities, and believe that on balance, being a buyer from current levels and below will look smart 6-12 months out.

A few thoughts:

  • The possibility of a trap door to the 2,300-2,400 zone on the S&P 500 should be taken very seriously, but you have to assume one can’t / won’t bottom tick price, and that buying should be approached as a process, rather than a snap decision.
  • I don’t think we will see 2,100-2,200 levels this year, barring some 9/11 or impeachment type of event (at which point US equities will be a Super Strong Buy).
  • I don’t think highs are in for the year.
  • I prefer buying US equities ex FANG/Tech.
  • I prefer buying US equities over foreign equities (the concurrent weakness in the USD and US equities will not persistent indefinitely, in my opinion).
  • The chirping on and on in January of this year about 2018 being a near guaranteed up year based on various statistics have all but disappeared. That makes me very happy and bullish.
  • Single stock short selling will, on balance, remain a gainful endeavor…even if the major indices were to melt up later this year.

I conclude this post with a story:

What the 2016 US Presidential Election Meant to Me

The week of the US Presidential elections (and on actual election day), I was on vacation (a diving trip), in the middle of the Pacific Ocean. I had spotty and slow internet. I had been very very short in the weeks preceding the election, and covered most of my short exposure prior to my vacation (this turned out to be the right thing to do, though it was a stroke of luck, not genius).

On election night November 8th, 2016, our boat was on its way back to shore. As the likelihood of Trump’s victory was increasing, S&P futures were falling… everyone around me (non markets people) were panicking, saying the US stock market would crash, that the US was doomed, etc etc… this gave me the itch to buy the dip.

I had low gross exposure, and some remaining single name short exposure. Around 10pm – 11 pm EST (I was in a different time zone), I was about to enter some buy orders (for the eminis), but stopped myself for the following reasons:

  • I had slow and unstable internet (slow enough such that the real time futures quotes were somewhat delayed on my phone).
  • I would be back on shore within 2-3 hours, upon which I would have stable internet.
  • I thought the decline in overnight futures would carry through to the US cash open…
  • I had already had an amazing year (returns wise) through November 8th, and wasn’t feeling particularly greedy at the time.

As a matter of fact, futures bottomed around the time I was going to start buying, and slowly drifted up all night, until us cash open…(I blame Icahn, Druckenmiller, and others for holding the bid!)

Bottomline: I was trying to bottom tick, and missed a huge profit opportunity. The current market character differs from November 2016, but I remain convinced that it is more costly to try to bottom tick a market, rather than approaching buying methodically.

 

Dennis Gartman: the Second most powerful man in the USA

They say that once a financial market signal is widely known, its predictive power diminishes / gets arbitraged away. over time.. yet the (inverse) Dennis Gartman would seem to defy this heuristic. This leads me to conclude that Dennis Gartman is the second most powerful man in the USA: who else has the ability to move mountains – er, markets – the way he does?

Normalization, Regime Change, and Adaptation

Some “financial experts” often claim that “history repeats” and sarcastically say “this time is different” (implying it never is)… are these heuristics correct? I think not: the Internet did not always exist, and the world has changed as a result of the internet. Cryptocurrencies have/are redefining ‘bubble’. These examples, sufficiently falsify the above-mentioned heuristics (yes, some things remain the same: we still die, we still depend on food/water to survive, etc).

For my own edification, I wanted to jot down a few disparate thoughts (that may interrelate):

  • Regime Change  and Normalization – Many have been talking about regime change that would take place in markets once nominal interest rates started normalizing (i.e., return to historic averages)…. in light of the recent activity in the volatility complex, what would happen if the volatility regime were to normalize as well? 2017 was the exception, not the norm…
  • Markets are adaptive because its participants are adaptive – I’ve observed that market participants’ behavioral tendencies are often coloured by the formative experiences associated with their past profits and losses… we seem to think that the same formula for success/failure in the past is what is needed for the present/future generation of profits… I have found this not to be true. As that Intel Founder famously warned: Innovate or perish.
  • “Don’t invest in things you do not understand” –  I’ve heard this expression come in vogue (again) in recent days, in the aftermath of the volatility complex blowups… my friend used to say, “If you don’t understand it, you should short it.”

 

 

Short Selling: The Best Kept Secret (?)

A certain venerable gentleman (and scholar) claims to have found the “best kept secret of short selling”. What is he referring to? Is he right?

Short Selling Funds are frauds and an embarrassment to the industry – according to a “John Doe”

A friend – I will refer to him as “John Doe” – known for cautioning against short selling over the last 1-2 years – escalated his rhetoric yesterday with the following claims:

  • “The success of shorting as a strategy is evident here”, referring to a diagram showing the # of short funds flat between 2007-2016.
  • “shorting as a strategy is the same kind of fraud that they claim to sniff out. Glad market sees it.”
  • “it’s a pipe dream that has a shelf life of a Twinkie.”
  • “There isn’t one short fund there w compounded long term double digit returns.”
  • “Because since shorting doesn’t actually make any money I consider anyone who does it for a living an embarrassment to the industry.”

Are the above claims true? Here’s what I believe:

  • “The success of shorting as a strategy is evident here” MOSTLY TRUE
  • “shorting as a strategy is the same kind of fraud that they claim to sniff out. Glad market sees it.” FALSE
  • “it’s a pipe dream that has a shelf life of a Twinkie.” TECHNICALLY TRUE, BUT IRRELEVANT
  • “There isn’t one short fund there w compounded long term double digit returns.” DEBATABLE
  • “Because since shorting doesn’t actually make any money I consider anyone who does it for a living an embarrassment to the industry.” I VEHEMENTLY DISAGREE

Let’s examine each claim, one by one:

“The success of shorting as a strategy is evident here” – MOSTLY TRUE

John Doe sarcastically wrote “The success of shorting as a strategy is evident here” in response to the following tweet:

John Doe is correct in implying that short selling – as a business – has been terrible (a fact, that is very well known among short sellers!).  However, I would not use HFR data as the basis of your argument. I can tell you firsthand that these data sets are quite imperfect (to put it politely). There is far superior supporting evidence, to the assertion that short selling has been terrible business:

  • Aggregate returns have been terrible (if not beyond terrible) in the above-mentioned time period.
  • The number of funds has remained flat (if not declined) between 2007 – 2016, despite hedge fund assets under management increasing 2x (if not more) during that time period. So actually, the effective allocation has declined by at least 50% since 2007!

There are some historically unprecedented reasons (post 2008) why short selling has been a terrible business. But no excuses, John Doe is correct: short selling business has been particularly bad business in recent years.

“Shorting as a strategy is the same kind of fraud that they claim to sniff out. Glad market sees it.” FALSE

The above claim that “shorting as a strategy is a fraud” goes beyond his usual “short selling is dangerous” rants (which I generally find to be well-intended and in the public interest, for the simple reason that short selling is so difficult).

I find John Doe’s claim false for the following reasons:

  • I am not aware of a single short fund that has been accused of fraud; nor am I aware of any that has ever committed fraud. I can assure you, however, that there has been fraud in the rest of the industry. Seeing that the rest of the industry currently constitutes 99.99% of the assets under management, it seems highly reckless (not to mention inaccurate) to allege fraud in the 0.01% minority, while there’s plenty of actual fraud within the 99.99%.
  • Of the few short funds that do exist, most historically do not claim to “sniff out fraud”. The short sellers who publicly sniff out fraud are a fraction of that tiny 0.01%. Even among those who publicly sniff out fraud, a large % of their books tend to be shorts they believe are structurally poor businesses, not frauds. Yes, their returns have been poor, but failure is not fraud. So let’s suppose John Doe were correct that short sellers who sniff out fraud, are frauds themselves. That would be inapplicable to the majority of assets dedicated to short selling. That is, his claim  would be substantially false because it would be inapplicable to the vast majority of money dedicated to short selling.

“it’s a pipe dream that has a shelf life of a Twinkie.” TECHNICALLY TRUE, BUT IRRELEVANT

It is a fact that short funds have a high mortality rate (“a shelf life of a Twinkie”), and die at a young age…just as hedge funds do in general:

Most hedge funds fail: their average life span is about five years. Out of an estimated seventy-two hundred hedge funds in existence at the end of 2010, seven hundred and seventy-five failed or closed in 2011, as did eight hundred and seventy-three in 2012, and nine hundred and four in 2013. This implies that, within three years, around a third of all funds disappeared. The over-all number did not decrease, however, because hope springs eternal, and new funds are constantly being launched.

source: https://ftalphaville.ft.com/2014/07/31/1913792/most-hedge-funds-fail/

So yes, short funds are hedge funds. Hedge funds die young. So what’s your point, John Doe (unless you’re alleging that short funds’ life span is dramatically even shorter than the already short 3-5 year life expectancy of all hedge funds!)

“There isn’t one short fund there w compounded long term double digit returns.” DEBATABLE

If John Doe is claiming that none of the short funds within that HFR sample can boast of a long term double digit returns…I am inclined to agree. However, I know for a fact that there have been at least three short funds that were able to boast of long term double digit returns – Rocker Partners, Water Street Capital, and the Feshbach Brothers’ fund(s). So if he is claiming that it cannot be done? I think that is simply not true.

“Because since shorting doesn’t actually make any money I consider anyone who does it for a living an embarrassment to the industry.” I VEHEMENTLY DISAGREE

I know people who have made money via short selling, so if the John Doe’s logic is:

If “one does not make money” , –> then “one is an embarrassment to the industry”.

and if there are short sellers who have and do make money…that would seriously undermine the John Doe’s “reasoning”.

There have been far richer hedge fund managers who have made a variation of the above argument: “where are the billionaires who made their money via short selling?” i.e., therefore short selling is a waste of time, waste of money.

At face value, the above is an excellent point: short selling is not the path to riches. I am not aware of a single billionaire – in the world – who made their money solely short stocks.

But it is my opinion that the above thought process misses the point.

Closing Thoughts

I personally like John Doe and believe that the vast majority of his tweets about short selling are not only true, but practically helpful to people in the business. I happen to agree with his bottom-line: most stock pickers in the hedge fund industry should not short stocks (in turn, their investors should also pay them far less, and/or purely on profits).

In this piece, I evaluated the merits of his claims (in this case, the lack of merit to his claims) on their own feet. Truth stands on its own feet. Is it possible that he believes and/or is propagating false claims for other motives?

Perhaps John Doe feels threatened by fund managers with short selling prowess, when it comes to the business of raising money. It is my understanding that John Doe had a good/great 2016, performance wise, and that he has attracted some outside money recently (and is looking to attract more money. Kudos to him).

When asked why should he care about short selling funds, John Doe clearly acknowledged that he sees them as competition for raising money. That is puzzling to me; if short selling funds don’t make any money, and John Doe is “glad market sees that”…lol, why and how are we your competition?

Maybe he feels threatened because the truth hurts; I know people deploying similar/greater amounts of money as John Doe, who had a similar/better year in 2016 than John Doe did…purely by shorting stocks. It is my understanding John Doe is a long only, with a concentrated portfolio of stocks. So this means that these people I know not only generated similar/better returns in 2016 as John Doe…their alpha was significantly higher. Imagine that.

I will close with two thoughts:

  • Why is it that a good number of high performing hedge fund managers (with great long term track records) vehemently disagree with John Doe? 
  • The markets humble all. (I seem to get humbled by the markets at least once a year!)

The Limitations (?) of Non-Discretionary Trading

Active fund management continues its decline (both in popularity/adoption, as well as in realized performance), even as passive investing moves in the opposite direction. One needs to look no further than [aggregate] hedge fund performance in 2016. Like 2015, yes, you had some notably good performers…only to be offset by notably poor performers.

Concurrently, “quantitative investment management” (which I prefer calling “non-discretionary trading”) remains in vogue. Look no further than the assets under management of AQR and the likes, of the world… or the political influence of Renaissance Technologies (though, in fairness, Rentech has been anything but an ‘asset gatherer’).

Question: What effect – if any – do the simultaneous popularity/success of ‘passive investing’ AND ‘quantitative investment management” today have on their future returns/losses (and the smoothness/volatility of those returns/losses) ?

Let’s oversimplify and say that the ‘alpha’ of the non discretionary participants arise 100% out of the discretionary active participants. If the actives are being pushed out because of both the passive AND quantitative trends… does that not diminish the alpha opportunity set for the non discretionarys? What if I were tell you that some of these non discretionarys use 10x-20x leverage…on their equities books?

Some of you may recall the “great quant meltdown of [August] 2007”, that occurred just under 10 years ago.Seemingly invincible quant funds experienced sudden and meaningful declines (e.g. -5 to -30%).

The likes of Soros, Druckenmiller, Paulson, etc… all great wealth compounders for themselves AND outside investors – eventually experienced real/meaningful drawdowns/losses.

Given that the capital flows towards passive and quant have largely occurred at the expense of active management… i.e., as passive and/or quant become more ‘crowded’ … are they truly immune to what the likes of Soros/Druckenmiller/Paulson all eventually experienced?

I think not.

ADDENDUM on 1/9/2017

Perhaps quant alpha now and in the future, just might (also) be derived from the negative alpha of other quants. For example:
BlackRock Quants Sustain Record Losses in Setback to Fink Plan

BlackRock’s main quantitative hedge-fund strategies — which use computer models to sort through vast amounts of data to pick out patterns — were on track for losses in 2016, according to a monthly client update sent out in late December. Of the five included, four were set for their worst returns on record, data through November showed.

I don’t what the sources of the losses were..but it is a possibility worth entertaining.