The Perils of Shorting

An Initial Caveat This column is inopportunely written.

Inopportunely for you, the reader, that is. The cardinal rule of investment advice is that counsel sounds its wisest when it’s at its stupidest. The most popular investment speech I have ever heard--a standing, clamoring ovation--was the exhortation to buy anything related to China, two months before the 1997 Asian financial crisis. The second-most-popular was from a Putnam strategist in 1998, plugging giant consumer growth stocks. Not as disastrous as the China advice, but not useful guidance, either.

This column mines a similar vein. It arrives eight years into a great stock/bond bull market, when shorting has never performed worse and when investors have never been more willing to dismiss the investment strategy. As my argument will make clear, I am not certain that shorting is ever a sound idea--but to the extent that it is, now would be among its soundest moments. Thus, as with much investment advice, this column serves as something of a contrarian sign.

(Such is the fate of a market pundit. Tell the people what they need to hear, get yawns. Tell them what they wish to hear but should not, receive applause.)

Well, it is what it is. I've been meaning to write about this topic for a while, after watching how shorting was portrayed in the film, The Big Short. Then, the CFA Institute published a brief article on the topic, titled "Lessons from a Legendary Short Seller." So, the timing might be bad, but the thoughts are fresh and the intent pure. (Hmmm, I'd better not try that argument in confession.)

Ungentle on the Mind The movie artfully captured the angst of shorting. Psychologically, the tactic runs counter to how other investors think. Owning securities requires optimism, both about the current state of affairs and about future prospects. Investors who are long wish for good things to happen. Those who are short do not. Successful long investments can be feel-good stories for all involved. Profitable shorts, not so much.

That tends to make those who short into pariahs. Corporate executives dislike them. Wall Street analysts dislike them. Longs dislike them. It's not just that shorts succeed when others fail. It is also that their mind-set is anathema to the mainstream. Shorts are disliked--and most people would prefer not to be disliked. That shorting does not suit most people's personalities came through in The Big Short, where most of the heroes were, to put the matter kindly, conventionally abnormal.

The Big Short also illustrated the unhappy math of shorting. Purchase a stock, and your financial commitment is complete. Unless you bought that issue on leverage, you will not be asked for more collateral. Not so with shorts. An initially bad short may lead to a margin call, whereby the investor must place more into the pot, as with a poker game.

This, too, is disconcerting. It's troubling enough to face margin calls while investing for one's own account; the additional investment might end up being good money chasing after bad. But it's far more difficult to do so with other people's assets, then being forced to explain why to them. Such was the case with The Big Short's Michael Burry, portrayed by Christian Bale, who was rapidly abandoned (and loathed) by his clients.

Three Hurdles In The Big Short, the shorts' troubles were very much rewarded. We knew that going into the theater; it would have been a very different film, with a very different message, had the protagonists lost their shirts. In real life, of course, not all short trades that begin badly end well. Many short positions that initially lose money later lose more money, then more money.

Such situations give the short investor two ways to fail.

One is, quite simply, by being wrong. Being short does not mean being immune to investment errors. In the late '90s, I talked with an investment manager who gleefully explained to me that

The second is to be right about the fundamentals but to be much too early. The CFA article details the most famous such incident, when hedge fund manager Robert Wilson shorted Resorts International in the late 1970s, reasoning that its highly profitable Atlantic City casino would be beaten by competition from Las Vegas. He was eventually correct--but not before being forced to close out his position at a $350 million loss, with Resorts stock rising to $190 from $15 in a few short months.

(In another example, I recall being amused by Jimmy Rogers’ mid-'90s claim that the next generation would prefer coffee to soft drinks. That seemed to me to be ... unlikely. However, time proved Rogers correct, as coffeehouses have boomed since then, at the expense of sugary drinks. But how to profit from that knowledge by shorting? I know of no short trades that would have worked over the next few years after Rogers’ prediction, whether of the commodities themselves or in the stocks of the companies that operated in those businesses.)

Finally, there’s the simple but inarguable point that the natural direction for stocks is up. Most companies, most years, generate more cash than they distribute, so they end the year with more assets than when they started. Recessions can temporarily alter that math, and rising interest rates will cause other problems, but the fact remains that those who short stocks fight the odds. To be successful, shorts must 1) be correct about a company’s fundamentals; 2) have their insights be recognized by other investors sooner rather than later, and 3) benefit from the favorable tide of a neutral-to-negative market.

Those are three formidable “musts.” There are times when all three conditions align. Perhaps this year will prove to be one of them. However, that is not the way I would choose to bet. This game is just too hard to play.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.