This commentary originally appeared at 8:36 a.m. EDT on Oct. 8 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.
With what seems to be under the guise of sound twenty-first century central banking, the Fed's policy of providing ever more easing through the manipulation of interest rates and even possibly aiming at raising asset prices (such as equities), I continue to hear the following objections from many investors and traders:
- Why bother selling short?
- Isn't short selling a mug's game?
Over the years, in search of a variant view, my analysis has often led me to reject general expectations and orthodoxy. At times, this has put me at odds with consensus, as I am sometimes bullish when others are bearish and bearish when others are bullish.
Sometimes I get it right -- sometimes I get it wrong.
Markets are invariably moved by the unexpected or what the crowd is not anticipating, particularly at inflection points. Part of my job (as I see it) is to game whether the crowd is correct of view or wrong (and should be faded). Legendary hedge fund manager Michael Steinhardt once said that developing a variant view is what puts distance between ordinary and superior investment performance.
As we all know, the objective of establishing a profitable, non-consensus view is easy to talk about but hard to isolate in analysis and put into practice. Since the crowd is more typically optimistic, over the course of time, this pursuit has led me to specialize in selling short -- and, at times, I have maintained sizeable short positions (even as stock markets advanced).
It appears the basic objections to short selling are that:
- when economies stumble, public policy (fiscal and monetary) comes to the fore and defends against an acceleration of economic and corporate profit weakness and often inhibits natural price discovery;
- risk and reward are asymmetric in short selling;
- the historic average annual positive return for equities is an insurmountable headwind; and
- the exercise of selling short is analytically time-consuming -- long ideas are dished out on a silver platter by Wall Street's research departments and are usually confirmed by management, which is not true of shorts.
I couldn't disagree more. Financial concepts have their seasons, and the market's numerous dives over the past decade combined with the uniqueness of today's structural worldwide economic challenges and the increased frequency of black swan events suggest that, when timed properly, a great deal of money can be made on the short side.
Sometimes a market gets terribly overvalued -- as it did in the late 1990s, when investors adopted the notion that the DJIA was destined to reach 36,000 (i.e., that there shouldn't be a risk premium on stocks) or embraced the notion of a new paradigm (i.e., an uninterrupted economic boom), which created unique opportunities on the short side.
Other times (more often than the above condition), individual securities or sectors are embraced by market participants and levitated to unimaginable valuations, which also creates an opportunity on the short side.
Mainly, it seems to me that opportunities to challenge biases are much more pronounced and more easily identifiable on the short side, no matter what the market conditions are, mainly because those searching for such weaknesses are substantially in the minority. And few are comfortable with the short side, which makes for an inefficient market.
Investors want to look on the bright side. Individual and institutional investors and corporate managements are invariably biased and bullish. How else to explain that nearly every money manager interviewed in the media is constructive? As well, consider whether you have ever witnessed a media interview with a corporate executive who was bearish on the future of his company. In my numerous appearances on CNBC, I have rarely (if ever) encountered such an animal. When is the last time you saw a downbeat CEO on Jim Cramer's "Mad Money?"
Warren Buffett put this more eloquently in his description of corporate truth telling in a letter to Berkshire Hathaway BRK.A / BRK.B shareholders in the late 1980s. In explaining his absence of an interface with management, he wrote that "corporate managers lie like ministers of finance on the eve of devaluation."
As always, Buffett was ahead of the times.
That said, poor management, frauds and eroding company or industry trends always will be in fashion, regardless of market conditions. This occurs despite the appearance of short selling as a mug's game or as a losing proposition based on the headwind of longer-term positive historic trends in equity returns.
Finally, more than any time in history, it can be argued that the secular headwinds (e.g., fiscal imbalances, structural unemployment, debt-laden private and public sector balance sheets, etc.) to worldwide economic growth represent powerful gusts that challenge a smooth and self-sustaining trajectory of global economic growth.
These factors (and others) are likely to lead to a more tentative and inconsistent growth backdrop in which corporate managers will likely find it more difficult (than in the past) to navigate the currents.
In summary, short selling and hedging seem to me to be a necessity in an increasingly uncertain world. After all, farmers do it, oil exploration companies do it, miners do it, even property owners do it by selling forward with long-term leases.
Moreover, short selling creates portfolio stability and a hedge against the inherently positive bias of analysts, managements and even human nature. Rather than being a mug's game, I have concluded that short selling is a useful tool that can provide profits in almost any market setting.
From my perch, the construction of a short is almost as important as the short itself, especially given the asymmetric risk/reward, which provides investors with an opportunity to capitalize on short-selling opportunities with some degree of comfort. This can be accomplished by buying puts or, as I like to do, through purchasing out-of-the-money calls as protection against the short (and allowing us to define risk). This strategy also serves to buy time for the short catalysts to develop.
One should never be obsessed with short selling or any specific investment strategy, but given that there is little permanent truth in the markets and given the aforementioned factors that will likely weigh on global economic growth, I have concluded that short selling is a necessary part of an investor's repertoire -- or at least mine.