The skeptics on Wall Street have gone missing.
As the stock market has surged to records — unbowed by recession, pandemic or warnings of a dangerous bubble — activity has dwindled to a nearly two-decade low for the traders known as short sellers, who make their money betting stocks will fall.
This saddens nearly no one. From small-fry investors to members of Congress, critics paint short sellers as merchants of pain. People around the world celebrated early this year when GameStop’s stock suddenly hurtled higher, causing billions of dollars in losses for short sellers. Many called it a long-due comeuppance.
But academics and short sellers themselves say they provide an important service suited for just this moment: pushing back against stock prices that may be rising too high, too fast. Despite concerns about the pace of the economic recovery and high inflation, the S&P 500 has set 65 all-time highs so far this year, with the latest coming on Monday.
Some critics say stocks look overly expensive, with some broad measures of value close to historical highs. Fewer short sellers in the market means there’s less selling pressure tugging downward on those prices. It can also mean fewer investors looking for overvalued stocks or ferreting out fraud.
“This is the thing that short sellers do, they lean against the wind,” said Charles Jones, a finance professor at Columbia University’s business school, who has researched short selling. “If you have short sellers who are not afraid to do that, you will not get prices that are too high or too low, which is what I think we want when we are allocating capital.”
Jones’ research of Wall Street in the late 1920s and early 1930s, for example, looked at a group of stocks that were particularly expensive to short, which discouraged short sellers from targeting them. They went on to have returns that were 1 per cent to 2 per cent lower per month than other stocks of similar size, suggesting that they had been overvalued.
When investors short a stock, they borrow the shares from someone else and sell them. Later, if the stock falls as the short seller expects, they can buy the shares, return them to the lender and pocket the difference in price.
So it’s no surprise that short sellers regularly get blamed for driving stock prices artificially low. During the 2008 financial crisis, a few days after the collapse of Lehman Brothers, U.S. regulators temporarily banned the shorting of financial stocks, fearing short sellers would undermine already weak trust in them and trigger a run on the system.
Nearly four years later, though, a study by a New York Fed economist and professors at Notre Dame suggested the ban did little to slow the decline in bank stocks, which fell anyway. The restrictions also gummed up trading for bank stocks, raising trading costs in the stock and options markets by more than an estimated $1 billion.
Shorting activity has been trending down since July 2008, a few months before that temporary ban. Then, it was nearly twice the force it is now, accounting for 2.61 per cent of all the shares in S&P 500 companies. Just 1.35 per cent of all the shares in S&P 500 companies were sold short in August, according to data compiled by FactSet.
The stock market’s mostly relentless rise since 2009 has prompted investors to pull dollars out of short-selling funds, helping to thin the ranks of the contrarians. Why go short when everything is rising?
“You have to look at what is causing the market to reach all-time highs,” said Carson Block, founder of Muddy Waters Research and one of the industry’s best-known short-sellers. “It is most definitely not that humanity is at our all-time greatest state.”
Instead, he said a big reason is the ultralow interest rates set by the Federal Reserve to resuscitate the economy. Those low rates have sent waves of cash into the stock market, and critics say they’re pushing up prices indiscriminately and allowing weak companies to hold on.
Block specializes in rooting out fraud, and one of his earliest victories came with Sino-Forest, a company that was once Canada’s most valuable publicly traded forestry business. Block released a report in 2011 calling the company a “multi-billion dollar ponzi scheme” that was overstating how much it had in timber investments.
Its shares quickly fell as the report reverberated, and the company pushed back on the accusations. But it ultimately collapsed in what an Ontario securities regulator called “one of the largest corporate frauds in Canadian history.”
Short sellers have also been credited with helping to publicize financial practices at Enron and Tyco International, two of the biggest U.S. corporate fraud cases, in the early 2000s.
Of course, short sellers also get it wrong sometimes. Tesla was a favorite target for years, with short sellers betting founder Elon Musk’s visions for the electric-vehicle company were overly grandiose. Tesla recently posted a record quarterly profit and is one of the few companies in the world worth $1 trillion.
Not all short investors are betting only on stocks to fall.
Consider Marc Regenbaum, a portfolio manager at the Neuberger Berman Long Short fund. Most of the mutual fund’s investments do well when stock prices rise, but it reserves some of its holdings for shorter-term short sales.
Regenbaum acknowledges the frustration that comes after identifying seemingly good candidates to short and then watching their prices climb. A rising tide has sent nearly 90 per cent of S&P 500 stocks higher over the last year. But he said he still believes shorting some stocks can help manage the fund’s risk and offer steadier returns during turbulent markets.
“Everyone thinks of shorting as this element of speculation and making absolute returns, as opposed to hedging things out and offering a smoother ride for the underlying investors,” he said.
Doug Ramsey, chief investment officer of the Leuthold Group, says the average stock in the market recently looked more expensive than it did at the height of the 2000 dot-com bubble, based on several measures. The Leuthold Grizzly Short fund has roughly halved in size in three years, down to $51.3 million US in assets at the end of June.
Ramsey said the stock performance between good companies and bad ones could separate once again, offering better rewards for short sellers, after the Federal Reserve pulls back on its support for markets.
Short sellers need the help. The average stock mutual fund that reserves some of its portfolio for shorting has returned an annualized 7.2 per cent over the last five years, less than half the return of an S&P 500 fund, according to Morningstar. The year-to-year difference can be even more stark. Consider 2013, when the S&P 500 returned 32.4 per cent. Hedge funds with a bias for shorting lost 18.6 per cent that year, according to research firm HFR.
But the Fed earlier this month announced it’s paring back on its monthly purchases of bonds. Many investors expect it to begin raising short-term interest rates, which would be the more momentous move, next year.
Block, the activist short seller at Muddy Waters who sometimes spars with his critics and haters on Twitter, said he’s not anticipating quitting. At least, not as long as he thinks he sees the economy and markets being mismanaged by people he considers fraudsters.
“I think this is the right thing for me,” he said. “It’s a way to try to monetize my constant state of alarm, my constant state of dissatisfaction at the dystopia unfolding all around us.”
