Good times could soon run short for short-sellers
After a couple of wildly successful years, short-sellers may have to work harder to stay ahead as the economy improves
By Larry Dignan
July 9, 2002
|
Is Wall Street's most profitable trading tactic in recent years about to become a riskier proposition? Short sellers have been raking in money since the market started dropping in 2000, but there are signs that things could become more difficult soon.
Short selling means borrowing shares to sell, then "covering" the loan by buying the company's stock on the open market. Short sellers profit from the difference between price at which they sold and the price of covering. If a stock's price has steadily increased until the short loan is due, shorts lose money because replacing the borrowed stock costs more than what it yielded in the initial sale.
Needless to say that the bear market has been pretty good for shorts, who largely bet that a stock will fall. In 2000, the dot-com bust gave shorts healthy returns; in 2001 it was an economy teetering on recession and ongoing woes in the telecommunications sector; and in 2002 it's a buyer's strike on Wall Street with a stream of bad news about corporate accounting.
"A month ago there were steadily improving economic numbers," said Dale Schmidt, a portfolio manager for the Potomac Funds, which features mutual funds that short stocks. "But things haven't picked up largely because of weak corporate confidence."
Through June 14 -- the latest available data available -- short interest hit a record 7.21 billion shares on the New York Stock Exchange. That spike came after short interest slipped a bit for the month ending May 15. NYSE's previous record was 6.83 billion for the month ending April 15. It's the same story on the tech-heavy Nasdaq where short sellers have ruled the roost since April 2000. The Nasdaq said it had 4.61 billion shares short through June 14, up slightly from May's total. Short interest on the Nasdaq has held above the 4 billion share mark for all of 2002 with the exception of one month--February.
Is all that short interest too much of a good thing? Short sellers said the biggest risk to their gains is an improving economy, which will eventually boost corporate earnings. If the economic picture continues to brighten, it'll be a bad time to be short. If stocks gain, short sellers may have to cover--or buy shares--thereby pushing stocks even higher.
"Our lives haven't become more difficult, but they could," Schmidt said. "Stocks are less undervalued now and could even turn up at some point."
Of course stocks haven't turned up, but short sellers note the tide could turn at some point. In the meantime, folks like Schmidt will keep on racking up big returns.
Potomac's U.S. Short Fund, which goes up when the Standard & Poor's 500 Index falls, has a year-to-date return of 13.8 percent through the first half of the year, according to Morningstar. The fund also performed well in 2001 and 2000, bringing in returns of 11.7 percent and 9.7 percent, respectively.
It's a similar story for Potomac's Internet Short Fund, which has had double-digit returns for wo-and-a-half years. Potomac's Small-cap Short Fund is up 4.87 percent through the first six months of 2002, according to Morningstar.
The biggest boon for short sellers at the moment may be the every-other-day scandals. Some hedge fund managers said the fertile shorting environment has been prolonged by the likes of accounting-impaired WorldCom and Enron.
One short seller noted that a "ruthless tactic" is to spread rumors about impending accounting worries to make a quick buck. "Accounting is tainting more companies than necessary," said a Boston hedge fund manager who didn't want to be identified. "Portfolio managers have been buried by Enron and now WorldCom and they are saying 'I don't want to own 2 percent of a company with questions about accounting.' "
However, it's not clear how long shorts will be able to feed off of accounting worries. For instance, despite the recent fiasco surrounding Worldcom's accounting mess, the Nasdaq actually gained ground in the days immediately following WorldCom's announcement. Morgan Stanley strategist Richard Berner said in a research note that he expects the WorldCom scandal to have a muted effect on the market and economy. "In our view this threat remains largely sector- and name-specific rather than systemic," said Berner, echoing other strategists.
If not for the run of accounting problems, investors may have actually been focused on an improving set of economic indicators and becoming more bullish, some short sellers said. After two years of market declines, some observers wonder how much longer the bear market will last.
Marshall Blume, a professor at the University of Pennsylvania's Wharton Business School, said shorting a stock is an inherently risky strategy that can backfire.
Blume favors a strategy where you pick two stocks in the same industry that tend to move together and short the overvalued one while going long on the undervalued one. "That may be the best way to hedge," said Blume. "To be a naked short is risky."
He said improving economic data and improving earnings would be enough to break shorts. As for accounting worries, "at some point investors are going to discount that," said Blume. "They might be already expecting more of this stuff."
That may mean that the easy money for the shorts is over. Stocks aren't nearly as overvalued as they were in 2000 and 2001, and that can't be good for shorts.
"Clearly shorting is less attractive than it was when the market was higher," the Boston hedge fund manager said "It's dangerous now to short the whole market, but our model is to identify idiosyncratic opportunities."
In other words, guessing what the market will do is a fool's game, but there are plenty of individual stocks for shorts to target. Notably, "technology is still fundamentally overvalued and there hasn't been one big capitulation yet," the Boston manager said.
Finding overvalued stocks was easier a few years ago, when people would pay any price for any story, said Fred Hickey, editor of the High Tech Strategist. "I'm not nearly as aggressive as I was," Hickey said. "I had a much larger short position two years ago."
For Hickey, short selling is something to do in moderation right now. He dubbed the practice as "more risky, but less stressing." It's risky because there has been a long market decline, but less stressful because it's unlikely a stock will burn short sellers by tripling value for no apparent reason.
Hickey usually doesn't short following a long market decline. Recently he's been picking up a few long-term holdings, though he said if there's a quick rally, he may boost his short position, especially in technology.
"It always comes down to valuation," said Hickey. "WorldCom was overvalued. The trigger doesn't matter."
|
