SHORT SELLING

Going long an investment asset means buying it in the expectation of a futureprice rise. Going short is the opposite: selling something you do not own in the hope of buying it back more cheaply in the future. Now that financial mar-
kets have primacy over hard asset markets, shorting should in principle be as nor-
mal an investment strategy as going long—increasing liquidity, driving down
overpriced stocks, and generally improving market efficiency (see “Market Effi-
ciency”). But as a percentage of the total market, short selling remains small,
perhaps in part because of the long bull market. Nevertheless, it seems clear that
the downturn in the equity markets and the crash in technology prices have bol-
stered interest in shorting.
For example, in August 2001, the New York Stock
Exchange (NYSE) reported that shorting activity increased to a record 5.91 bil-
lion shares for the month, the sixth consecutive month that short selling hit a
new high.
To sell stocks short, investors need to borrow them from willing lenders via
a broker. This involves putting up 50 percent of the short sale price as cash col-
lateral, paying a small fee for the borrowing privilege plus any dividends paid on
the stock while the position is open, and setting up a supply of credit, also at
some cost. These procedures tend to make shorting more difficult than holding
a security long.
Short selling also exposes the practitioner to considerable risk of loss: When you go long, your loss is limited to what you paid for the stock; but when you go short, your losses are potentially without limit as the price at which you can buy back rises ever higher above the price at which you sold. A further risk is that the lenders may recall their stock at any time. In less liquid markets, this creates the possibility of a short squeeze, where it is difficult to buy in at any price in order to cover the short position.
Why sell short?
The obvious answer is to profit from the impending de-cline of an overpriced stock, an overpriced industry, or, indeed, an overpriced market. One of the most famous shorting episodes was in 1992 when George Soros sold vast numbers of British pounds prior to the ster-ling’s collapse against the other European currencies to which it had been pegged.
Shorting can also provide efficient diversification as well as potentially
earning a higher return on cash collateral: Your cash continues to earn but you
are also making money from the short sale proceeds plus, if you can negotiate it,
a share of the interest the broker is saving by using your collateral rather than
borrowing from the bank. (However, short sellers, particularly individual in-
vestors, do not usually receive the full sale proceeds, though institutions can ne-
gotiate to receive some of the proceeds or interest on the proceeds while the short
position is open.)
But most short sellers are investment brokers and bankers hedging other
positions: for example, protecting long positions from a market decline with an
offsetting short position; or hedging positions that may be quite different from
the short position but which are related by covariance. Risk management has be-
come increasingly popular in recent years, even after the disrepute caused by its
failure in the late summer of 1998—and shorting is a prime tool in the risk man-
ager’s kit.
Short Selling Gurus: Steven Leuthold and Kathryn Staley
Short selling tends to be counterintuitive to most investors and, as a result, only a few sophisticated money managers and knowledgeable individuals use it as an active investment strategy (as opposed to a hedging technique). These professional short sellers look for companies with inflated reputations and prices, digging out unfavorable corporate information using a variety of techniques. One such is Steve Leuthold who works out of Minneapolis.
Leuthold employs a program called AdvantHedge, which he describes as “a disciplined quantitative short selling program that is entirely focused on large cap liquid stocks.” This means that short-sale candidates must trade in excess of $1 million per day and have a market cap of $1 billion—a universe of about 1,100 stocks. The focus on liquid stocks avoids the problems of short squeezes and low trading volumes, which can make covering difficult.
The stocks sold short by the program are selected by a proprietary Vulnerability Index based on such indicators as industry group relative strength and fundamentals, performance rating, volume accumulation, insider buying and selling, and earnings disappointments; and includes an array of triggers (short covering disciplines) to cover, monitor, and reduce short positions. The program can be used as an offset to some market risk without dislodging long-term portfolio holdings; as the short side of a market neutral strategy; or in a significant market rally as an aggressive shorting tool. AdvantHedge is always 100 percent short in about fifty different issues.
Leuthold is a student of markets and writes volumes on every aspect of market history and its relationship to the current times. To maintain a distance from the daily market din, he takes frequent, short leaves to concentrate on major trends. And among fellow professionals, he is regarded as one of the most all-encompassing of market strategists (see “Technical Analysis”).
Another noted short seller of U.S. equities is Kathryn Staley. In her book The Art of Short Selling, she lays out the four clues she looks for when trying to identify short-sale candidates:

1. Accounting gimmickry: clues that the financial statements do not reflect
the true state of the company’s health, with overvalued assets and an
ugly balance sheet.
2. Insider sleaze: signs that insiders consider the company a personal bank
or are in the process of selling their stock.
3. A gluttonous appetite for cash.
4. Fad or bubble stock pricing, usually marked by a stellar price rise over a
short period.

Staley’s methodology can also be applied in the emerging markets simply by substituting the word country for company. In the dramatic market falls of 1997-1998, some emerging markets investments were sold off for the very same reason that certain U.S. stocks get dumped: Investors discovered that they were shoddily, even fraudulently, run.
Staley also points to what is often the main problem with short selling: being right but too soon. While a company may be overvalued, it may take longer than you expect for its price to fall and, in the meantime, you are vulnerable to margin calls if the price rises as well as the possibility of “buy-in” if the lender wants the stock back. As an old Wall Street rhyme says,

He who sells what isn’t his’n
Buys it back or goes to prison.

Counterpoint
Despite its contribution to market liquidity and efficiency, short selling still has
a vaguely disreputable image. Many observers consider it to be “betting against
the team,” an unsporting or even unAmerican approach to investment, which
can lead to severe market downturns. For example, it has been alleged that short
selling contributed to the 1987 market crash as part of index arbitrage and port-
folio insurance, although the use of derivative securities in such strategies seems
to have been far more to blame (see “Risk Management”). And Malaysian prime
minister Mahathir Mohamad wanted to make shorting illegal after the
1997-1998 collapse of his country’s currency and stock market, which he
blamed on short sellers.
Part of the U.S. regulatory response to the 1987 crash was the introduction
of circuit breakers as an attempt to slow downward market movements. These in-
clude the Securities and Exchange Commission’s (SEC’s) uptick rule, which in-
sists that for a short sale to be implemented on the NYSE or the NASDAQ, the
most recent price move must have been up. Such tight rules add to the greater
costs of shorting than of regular sales or purchases. And these costs have the ef-
fect of inhibiting traders with unfavorable information, giving markets an up-
ward bias.
The growth of indexing also increases the costs and dangers of short sell-
ing (see “Indexing”). If you short prominent stocks in an index like the Standard & Poor’s (S&P) 500 because their fundamentals are clearly slipping, you run the risk of losing out if the market rises dramatically since the questionable stocks will be swept along in the overall market fervor. But if you short stocks not in the S&P 500, there is no liquidity. For this reason, rather than shorting, it might be preferable to buy put options or sell stock if you think the market is near its peak.
Guru Response
Steve Leuthold comments:

The stock market’s exceptional rise in recent years has given birth to the concept that we are in a new era of investing, perhaps with the implication that shorting equities in these circumstances is a mistake. But such thinking is just an attempt to rationalize a mania. So I offer some tongue-in-cheek “new definitions for a new era:”
• Bear market: when stocks decline for a week.
• Major correction: when stocks decline for a day.
• Old-timer: a person who knows someone who lost money in the stock market.
• Cynic: anyone reminding you stocks can go down.
• Conservative: anyone without a margin account.
• Diversified portfolio: any portfolio with less than 50 percent of its assets in technology stocks.
• Risk: how much you can lose being out of the market.
• Inflation: historical phenomenon that used to adversely affect stocks.
• Dividend yield: outdated concept once used in valuing stocks.

Leuthold adds:

Few of today’s portfolio managers know much about short selling. In what had been seen as a permanent bull market, equity shorts and hedging were viewed as unnecessary. Of course, old timers felt the laws of stock market and economic cyclicality were only suspended, not revoked. I would say that the keys to our relative success shorting stocks in the biggest bull market of all time were the covering disciplines that we rigidly maintained.


Where Next?
After a long bull market seems to have ended, shorting is tempting. And yet shorting takes a different mentality from what most of us have. We are almost all products of a period in which markets have gone up for more than several decades. Shorting requires a certain form of tough-minded pessimism. And as in-dicated previously, shorting produces the possibility of infinite loss: You can lose more than you put up, with the potential that the sky is the limit.
So unless one is really psychologically conditioned to this and unless the
market has given definite indications that it is in a long downward trend, shorting is probably best left to the absolute pros and the people who give daily attention to the signals.
At the same time, shorting means you need no longer have an optimistic outlook and thus has understandable attractions for people with a contrary turn of mind or a “gloom and doom” view of the world (see “Contrarian Investing”). While many institutional managers such as mutual funds cannot go short, for those who can, it is just possible that it will be the investment skill that keeps them from financial disaster in a bear market.