By Nick Colas of DataTrek Research
Every investor is short something, even if they don’t think about their investment decisions or risk exposure in the same way a hedge fund might. For example, if you are underweight equities right now versus a benchmark or your typical allocation, you are essentially short stocks. Today we discuss the very specific rules traders use when shorting a security and how they apply to all investors. The bottom line: every short is just a trade, and eventually you must cover.
“Every investor is short something.” I (Nick) first heard that bit of wisdom in the early 1990s from an analyst at Harvard Management, the organization which manages that university’s endowment.
His point was that the range of possible investments is so wide that no institution or individual investor can possibly run a truly “neutral” portfolio. This is even truer today. For example, most investors are short virtual currencies because they don’t own even a small allocation of this now trillion-dollar but still deeply fragmented and complex asset class. At a more mainstream level, many investors are short equities in that they are underweight stocks versus their benchmarks or historical allocations due to this year’s volatility.
Traders know that shorting stocks requires strict adherence to a set of rules, and for this week’s Story Time Thursday I will describe 4 of them and how I think they apply to today’s investment environment:
#1: Valuation alone is not enough. At the old SAC, rookie analysts often made the mistake of pitching Steve short ideas based on valuation metrics like PE ratios or EBITDA multiples. His reply was always the same: “Everyone owns a calculator. Math is not an edge.”
I think about this every time we discuss our longstanding overweight to US equities versus rest of world stocks. Yes, US stocks are much more expensive, at 18x forward earnings expectations versus 11 – 13x for European, Japanese and Emerging Markets equities. There are good reasons for that, from the dollar’s reserve currency status to American public companies’ keen focus on profits, to the world’s most vibrant venture capital industry. While it may be tempting to add non-US equity exposure here as a “cheaper” alternative to US stocks, we would advise against it.
#2: A well-constructed short investment thesis requires identifying specific catalysts that will affect the price of a stock, and that means knowing exactly why the name appeals to its current base of shareholders. Hedge funds look at which institutions own a stock and why they like it in order to judge if a short argument has merit. After all, those are the asset managers that (ideally) will be spooked out of a stock on bad fundamental news.
This point is what makes being short/underweight US stocks such a difficult call just now:
Everyone knows only recessions kill inflation. The historical record is crystal clear on that point. It is just as obvious as a PE ratio, which means there is no investment edge in this observation.
Equity investors don’t even care about recessions per se; they care about the effect recessions have on earnings.
Q2 2022 was a record for S&P 500 earnings, which were 39 percent higher than 2019’s quarterly run rate. By way of comparison, nominal US GDP is only up 17 percent from Q2 2019 to Q2 2022. Despite a slew of headwinds, from supply chain shortages to labor turnover to questionable WFH productivity, American companies have delivered simply stellar margins and earnings.
Unless the US economy goes into a tailspin very soon, Q3 and Q4 earnings should be broadly in line with Q3 or even slightly higher given normal seasonal trends.
The short case for US stocks therefore requires answers to 4 questions:
1) when does a US recession start,
2) what will corporate earnings power be when it starts,
3) how much will earnings decline, and
4) how quickly will they recover?
The fact that monetary policy works with a lag only makes answering these questions even harder. Half of the art in shorting stocks is timing the entry point for a position. And as the old trader’s saying goes, “early is the same thing as wrong”.
#3: Avoid crowded shorts. There is nothing more frustrating to short sellers than being right on a fundamental call but wrong on a stock because too many other hedge funds are short the same name. On top of that, short interest is public knowledge so there is also the risk of simply being squeezed out of a position.
One way to think about the June 16th lows for US stocks is that it represented the apex of a crowded short. Too many investors saw the S&P 500 down +20 percent on the year, the VIX at 33-34, and Treasury yields ripping to new highs and simply said, “I’m out”. The subsequent rally has been, therefore, a classic short squeeze. With the VIX now at 20, that squeeze is over, and stocks have to justify further gains based on fundamentals and macro developments.
#4: Shorts are trades, not investments. By the time a company is public, it usually has some intrinsic value. This can wax and wane with management competence, economic cycles, competitive forces, and other issues. If things truly go off the rails, the company’s board either replaces management or splits up/sells the business. Very few public companies go to zero. This is why every short seller has a target price where they cover in mind before they initiate a position.
If one is negative on stocks at current levels, the only relevant question to ask (and answer) is “where do you cover/add equity exposure and, more importantly, why is that the right level?” One of the hardest things about shorting a stock is covering when it hits your price target. Maybe it will go lower… Maybe it’s even one of those rare stocks that goes to zero. And why even cover when the position is working for you?
The answer is, as a wise old SAC trader once told me, because “this game is rigged to the upside”. The upshot here is that if one is underweight stocks right now, set a target price or range where you will add equity exposure and do your best to stick to it.