The Value in Listening to Bears

Short sellers are a breed apart. Because they’re going against the trend, and numerous stakeholders, they possess a tenacity and conviction that can be breathtaking. When I was investing in hedge funds at JPMorgan, I especially enjoyed meeting with bearish managers. For a start, they do some of the best research. And while a long position might require only modest upside to justify its inclusion, shorts are often believed to be fraudulent, or to have fatally flawed business models. A short seller’s pitch has passion laced with a paranoid suspicion of authority, financial statements and basic human goodness. It can be exhilarating to hear such well-constructed certainty that much you believe right in the world is wrong. These people are fearless, the ones you’d want with you in that foxhole.

In The Hedge Fund Mirage I recount meeting with short-seller Marc Cohodes, who was convinced that men’s clothing store Joseph A Banks was misreporting its financials and would soon collapse. He brandished ads offering “Buy One Suit, Get Two Free” as evidence of an unsustainable promotional strategy. That was over fifteen years ago, and they’re still in business. Examples of such bets gone awry are easily found. For a while, Marc Cohodes was disillusioned with the business (see A Hedge Fund Manager Finds More to Like in Farming), but has since returned (see The World According to a Free-Range Short Seller With Nothing to Lose).

Conversations with hedge fund managers are rarely boring, but they’re especially absorbing when discussing short positions. The depth of research and unshakeable conviction are awe-inspiring. Even though many are wrong, the notion that an apparently successful company is really a house of cards remains riveting.

Nonetheless, shorting profitably is harder than making money on long positions. Almost everyone else involved wants the stock to rise, and because short positions grow when they’re moving against the short seller and shrink when the price is declining, they’re harder to manage. I often used to ask hedge fund managers why they bothered shorting stocks at all, instead of simply shorting index futures and investing all their effort in long ideas. I never received a satisfactory answer – when companies or sectors do collapse, such as Enron, sub-prime mortgages, Lehman Brothers or Valeant, those who called it draw immense satisfaction, media accolades and more clients.

Some of it is marketing. Investing is one of the few areas where delivering a product (i.e. investment returns) that are inferior (i.e. lower) than others can still be valuable, if the returns are uncorrelated. Holding something that will reliably zig when others zag is better than holding cash in a bear market. There’s a chronic shortage of such opportunities. Short-seller Jim Chanos has cleverly exploited this with a performance fee on his hedge fund that’s calculated based on the inverse S&P500 return. So if the market is up 20%, anything he delivers that is better than down 20% draws an incentive fee, on the basis that improving on a simple 100% short index futures position is worthwhile. In a rising market, even holding treasury bills with this fee structure can be profitable.

The Economist recently profiled Soc Gen’s strategist Albert Edwards, a “steadfast prophet of gloom”. Edwards might be described as a “permabear”, constantly regarding the glass as half empty. The appeal of such thinking is that, while investing is built on a cautiously optimistic worldview, considering a contrary opinion is stimulating and can engender protective wariness. We’ve endured a two year bear market in energy infrastructure that just possibly ended last month. We often find the more interesting conversations are with investors who have avoided energy entirely. They clearly assessed the sector differently. When the uninvested become bullish, as some are, higher prices soon follow.

The Economist said of Albert Edwards, “…his talent for imagining the worst is valuable. If you have a vague anxiety, Albert will give it form.” Edwards has been calling out excessive leverage, ruinously low interest rates and China’s precarious GDP growth for years. He’s been wrong on all three, but the strategist almost never runs out of time because, unlike a hedge fund manager, he doesn’t run out of other people’s money with which to bet.

James Grant, founder of Grant’s Interest Rate Observer, retains a loyal following. His writing flows effortlessly off the page, both stimulating and entertaining the reader. It’s as well he possesses such talent, because his relentlessly bearish views on bonds during a career-length, secular bull market have only been tolerable because of their erudite wrapping. Grant’s career as a money manager would have been brief; he has made sensible choices.

The Bears are Roaring

Albert Edwards is well known among European clients of Soc Gen for predicting the break-up of the Euro. In 2010 he criticized the Greek bailout as delaying the inevitable. Today he cites weak Italian productivity as a growing source of instability. Since Italy is “locked in the Eurozone”, its “effective exchange goes up because its labor costs are rising.”

The Euro is arguably behind Brexit – by staying out of the Euro, Britain’s economy grew faster. This attracted more east Europeans seeking jobs and contributed to politically unacceptable levels of immigration, fueling populist outrage and the vote to leave the EU.

In the 1990s a trader working for me insisted that the Euro (then not yet formed) was a failed concept that would never be realized. Unlike Soc Gen’s Edwards, this trader did run out of money to maintain losing bets against currency convergence in the Euro’s run-up. I spent too much time with him listening to why the proposed single currency was a bad idea destined to fail.  In recent years, I’ve often thought I should send a plastic bag of Euros to his home in Florida.

Albert Edwards has sensibly avoided the constraining allure of managing money, which is why he can still challenge us to contemplate the unthinkable. Along with a break-up of the Euro, he’s predicting a U.S. recession and an “unraveling in China.”

These are not consensus views, and not our forecast either. But the attraction of bears is to get you thinking about surprises. Import taxes (i.e. tariffs) and the continuing Federal government shutdown are not conducive to strong U.S. growth. Both are easily fixed in Washington, but while they’re not, the risks of an economic slowdown rise. It’s why bearish views are gaining attention.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

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4 replies
  1. Tom Sandlow
    Tom Sandlow says:

    Simon,

    I was surprised by your comment, “I often used to ask hedge fund managers why they bothered shorting stocks at all, instead of simply shorting index futures and investing all their effort in long ideas.” I’m curious as to your thinking. It seems to suggest than investors can create alpha on longs, but not shorts. Why would that be? Can’t the investment processes that are used to find undervalued stocks be used to identify overvalued stocks (with some modifications). Although the math is not so great for short sellers (positive drift of stock prices and negative gamma of short positions – you get shorter as you are wrong), I’ve always thought the advantage short sellers have is that they are fishing in a pond with very few other fisherman. The world is overpopulated with people looking for good stocks to buy, but must less populated with good stocks to short. Aren’t there almost equal amounts of each? Doesn’t it make sense that with less capital focused on short selling there would be more opportunities?

    Tom

    Reply
    • Simon Lack
      Simon Lack says:

      Tom, thanks for your comment. I just found so many cases where short positions had caused problems. You’d think it would be less crowded given the difficulty, but it didn’t seem that way to me when I was in that business (admittedly >10 years ago so may have changed).

      Reply
  2. Elliot Miller
    Elliot Miller says:

    If I were a passionate, rational bear, rather than shorting a stock (particularly one which pays a dividend) I would rather buy puts. Granted puts are for a short term and disintegrate over their lives, but even paying a premium for the put seems far less risky than shorting.

    Reply

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