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Selling something you don’t own seems a pretty alien concept to me. I struggle to find any business models for which this is a key strategy. The exception is shorting of stocks and other securities which is a huge business on Wall Street that is carried on by many hedge funds and aided and supported by household name investment banks who execute trades and through prime brokerage services provide extensive logistical and financial support to hedge funds. And in point of fact, most of the household name investment banks operate huge hedge funds internally which they euphemistically refer to as proprietary trading.

In this report, I contrast the risk and reward of shorting versus buying stocks. When you unravel the economics and risk/ reward of shorting, it is clear to me that this is a highly risky, low return strategy. As argued in this report, I see shorting as a losers game if employed consistently over time as opposed to buying stocks which is a winners game. I see shorting as a niche strategy that is applicable on a short term trading basis for a very limited number of stock trades. I think you will agree with me as I go through the major risk and reward elements of shorting.

Why then is this such a big business? I think that it is because the perpetrators have evolved a widely employed strategy that uses shorting and illegal naked shorting to actually control prices of many stocks, moving them down in a predictable way. This converts short selling of stocks into a predictable business with extremely high returns and low risk. In prior blogs, I have laid out the role of the Depository Trust and Clearing Corporation which is responsible for clearing and settlement of essentially all stock trades in the US and is also the depository for all traded shares. DTCC is a private company owned by the same Prime Brokers who are so prominent in shorting. My prior blogs have shown how the DTCC allows the creation of counterfeit shares through illegal naked shorting. In essence then, the Prime Brokers are the key players and referees in the short selling business.

Background on Why I Wrote this Blog

This is now the ninth blog of my series of blogs, the central theme of which is that illegal naked shorting is at the heart of widespread manipulation of stocks by hedge funds. I know that almost all of you already understand how stocks are shorted legally, but for those who may need a refresher, here is the boilerplate description. An investor who believes that a stock is overpriced and will decline in price can capitalize on their analysis as follows.

• They borrow shares from an owner of the stock.
• They must pledge collateral in the form of cash or other stocks that is somewhat more than the value of the borrowed stock
• They are essentially taking out a loan from the broker lending the stock and must pay a negotiated interest payment
• If the stock price goes down as they are betting, they buy stock in the open market and return the borrowed shares to the broker from whom they borrowed stock.

This idea for this blog came as I watched one of the cable news business networks the other day and listened to one of the guests go on about short selling. This person said something that really caught my attention. He was speaking about a very successful hedge fund manager who has been intimately tied to short selling and stock manipulation. He said that what made this person such a great money manager was that he didn’t care whether he was buying or shorting a stock. He was just searching for the best trade.

The implication of this statement is that the investment potential of buying or shorting a stock is no different. The only important thing is being correct on whether the stock price will increase or decrease. I don’t believe this to be the case. I think that there is a great deal of difference in risk/reward between buying and shorting a stock. I think that shorting a stock results in a much greater assumption of risk and is much less attractive than buying a stock. This prompts this ninth in a series of blogs on illegal naked shorting that looks at the risks involved in shorting as compared to buying a stock.

Short Selling and Stock Lending to Support It is a Huge Business on Wall Street

Shorting of stocks is extremely widespread on Wall Street among hedge funds. Wall Street firms benefit handsomely from lending securities for shorting to hedge funds and collecting interest expense and other fees. In addition Wall Street firms themselves operate giant hedge funds that they euphemistically refer to as proprietary trading operations. Some estimates suggest that securities lending to enable short selling (in part) accounts for as much as 20% of net income for the large, household name investment banks. Retail investors, mutual funds and pension funds have not found shorting of stocks to be a profitable strategy. The paradox is why do some hedge funds and the Wall Street firms that support them embrace and profit mightily from shorting while other market participants can’t figure out how to make money doing this?

Liability for Short Sellers is Unlimited

The biggest risk when you short a stock is that your liability is unlimited. If I buy a stock, the worst thing that can happen is that I lose my entire investment. If I short a stock, there is no limit to my liability. A striking example of this occurred with Kalo Bios. This company was on the verge of bankruptcy and selling at about $0.25 per share. One retail investor shorted the stock on the thought that making $0.25 per share when the Company went bankrupt was a sure thing and they shorted 4000 shares thinking that they could make a quick $1,000. But alas, Martin Shkreli swooped in and manipulated a short squeeze that drove the stock to $40. 00 per share. See this link for more detail.  The retail investor quickly found themselves with a loss of about $160,000 based on a $1,000 investment. While this is an extreme example, it drives home the point that there is much more risk relative to the initial investment in shorting a stock than buying it.

Short Sellers Incur an Ongoing Cost

When you buy a stock, the money is invested and that is the end of the cost of the transaction. When you short a stock, you have to borrow the stock and pay interest on a loan roughly equivalent to the value of the stock that was borrowed. If the stock price increases you have to pony up more collateral or cash and the interest expense is increased. This puts a time urgency on the shorting transaction. Unless, the stock trades down sharply not so long after it is shorted, the short seller’s returns can be diminished meaningfully by shelling out cash for interest expense.

Short Sellers Have to Have Exquisite Timing

If you buy a stock and the price declines sharply for some reason and if you judge that this does not change the rationale that led to you to buy the stock, there is no out of pocket cost for holding on to the stock. You can wait, even if it takes years, for the fundamentals to come through. This is not the case with shorting. Let me give an example drawn from the HBO series Big, Little Lies. The stock broker husband of one of the lead characters Renata Klein (Laura Dern), is suddenly swooped down upon and arrested by the FBI for securities fraud which drives them into bankruptcy and the loss of their considerable net worth.

When Renata screams at him for an explanation, he replies that he had shorted a blood diagnostics company because he was totally convinced that the company was a fraud. He was ultimately right. However, the fraud went undiscovered for some time and the hype by promoters caused the stock price to explode on the upside. He was forced to put up more collateral and had to pledge all of their wealth as collateral, but lenders demanded still more. He was down so much that he couldn’t just fold his tent and walk away. In desperation, he chose to fraudulently pledge securities and cash illegally appropriated from accounts of his clients. The FBI arrested him for securities fraud. The lenders seized and liquidated the collateral he had pledged against the loan taking almost all of his wealth.

Sadly for him, the company ultimately was shown to be a fraud and went bankrupt.  He was completely right, but his timing was off. The point is that the short seller has to be right on their fundamental rationale and as importantly be right on the timing as to when this will be reflected in the stock price.

Short Squeeze is a Big Risk

There is also the risk that the short seller may encounter difficulty buying back the stock that was borrowed. Initially, they may get caught up in broad scale pessimism about a stock and became part of a herd of short sellers. Then with an abrupt and unexpectedly positive change in fundamentals the stock could surge ahead. Panicked short sellers in concert rush to cover the short, but this surge in demand for shares greatly exceeds supply and exacerbates the increase in price adding to the panic as I described earlier with the Kalo Bios story. This is a short squeeze.

In the Long Term Buying Stock is a Winners Game While Shorting Stock is a Losers Game

For investors who buy and sell stocks, the stock market is a winners’ game in which all investors can win. The economy, as measured by gross domestic product, can be expected to grow at an annual rate of about 2% to 3% over the long term, and inflation is running at about 2% which leads to nominal GDP growth of about 4-5%.  In the past stocks have risen at about the same rate as nominal GDP and this will probably be true in the future. Throw in a 2% dividend yield and the expected gross return is 6% to 7% annually. Adjusting for inflation of 2% that decreases purchasing power and taxes on dividends, the real return for those who stay invested is about 3% to 4% per year. Eventually, when an investor cashes out, they also have to pay a capital gains tax. This is what average investors who stays long stocks can expect. Of course, short sellers who stay long would be expected to have just the opposite outcome and to lose 3% to 4% annually. Buying stock is a winners’ game and shorting stocks is a losers’ game over the long term. Of course for the shorter term, there are situations is which shorting can lead to a positive outcome. Hedge funds will point to examples like Enron in which short sellers got a 100% return on their investment. However, Enron type situations are few and far between.  In contract, long investors can have nearly unlimited upside to their investment, many times multiples of their initial investment.

Shorting is So Anti-Social

I think that most investors find it a bit weird to be selling something you don’t own. This is just not common in real life and it seems so anti-social. When you buy a stock and the price increases, everybody wins. You win, other investors win, the company wins and its employees win. When a short seller wins, everybody else loses. I suppose that many hedge funds would have no problem with this. Driven by inexorable greed, all they care about is if they make money and other issues are immaterial. However, I think that shorting is much harder psychologically for the average investor, retail or institutional, to be so ruthless. This constitutes a major deterrent to short selling, at least to me.

Reasons for Shorting

When you step back and look at all of the disadvantages of shorting, you have to wonder why shorting is such a huge business. As with all debates, there are two sides. Advocates of shorting would say that it is easier to make money on short ideas as most investors are biased toward buying stocks. This means that there is less market efficiency on short ideas than long ideas and by focusing their analysis on the short side, hedge funds improve the probability of being right. There is a modicum of truth to this argument. However, in this day of cable business news and social media, there is a lot of information available to all investors. Also, there are armies of stock analysts working on both the buy side and the sell side who are pouring over much the same data as the hedge funds. I think that in terms of investing based on publicly available information, short sellers seldom have a meaningful information advantage over others.

Are Hedge Fund Managers Just Smarter Than Us When it Comes to Shorting?

Hedge fund managers claim that they are smarter than everyone else and accordingly demand higher fees for their investor expertise. However, statistics from Credit Suisse Hedge Fund Index indicated that from January 1994 to October 2018 – through both bull and bear markets – the passive S&P 500 Index outperformed their hedge fund index by about 2.25 % annually. This suggests that the aggressive short term trading strategies used by hedge funds produce decidedly inferior returns to passive investing in an index fund. Of course, some might still argue (spin is a better term) that only the best of the best hedge fund managers know how to use shorting as a profitable strategy. There is, of course, no data to support or refute this claim.

History of Shorting

In googling the history of shorting, I found a very interesting link  that suggested that short selling originated (kind of) with a the Dutchman Isaac Le Maire, in the 1600s who shorted the Dutch East Indies Company. Interestingly, after shorting the company he spread false rumors that some of its ships had sunk in storms. How interesting, false rumors are also routinely used today in short selling attacks. Over 400 years, such skills have been honed. Incidentally, he was unsuccessful in this short scheme and lost all of his money.

If you read Wikipedia you will see short selling being referenced as a factor in an English banking crisis in 1772 and the collapse of the tulip bulb bubble in the middle 1600s. Short selling was widely blamed for the US market collapse of 1928 and this was one reason for passing laws in the 1930s that are the core of current securities regulation. More recently, George Soros has gained fame as perhaps the most ruthless of short sellers. He became notorious for breaking the Bank of England on Black Wednesday of 1992, by shorting more than 10 billion pounds. This contributed to an economic downturn that devastated many working class families, but made Soros a legend in the hedge fund industry.

The practice of shorting gained much more importance with the rise of hedge funds. In 1949, Alfred Winslow Jones founded an unregulated fund that bought some stocks while selling other stocks. This is thought to be the origin of the hedge fund.  Michal Steinhart is broadly acknowleged as the Godfather who took hedge fund investing to a new and ruthless level in the 1960s, 1970s and 1980s. Jim Cramer learned the trade from Steinhart and explains in this you tube video how he used aggressive trading techniques including stock manipulation.

Move to Paperless, Electronic Trading Has Led to an Explosion in Short Selling

So short selling can be traced back over 400 years and has been cited as one of the causes of many crises since then. However, short selling really took hold after the new paperless electronic clearing and settlement system came into effect. I can’t draw a precise timeline showing a correlation between the rise to total dominance of the  DTCC clearing and settlement of all securities trading on the major stock exchanges to the rise of shorting and illegal naked  shorting.  However, from the 1990s through today, empirical evidence is overwhelming that the business model that depends on shorting of stocks has evolved to be one of the most important and profitable businesses for elite Wall Street firms and their hedge fund colleagues.

The transition to a paperless clearing and settlement system starting in the late 1960s added a new dimension to shorting stocks. It made possible illegal naked shorting in which the short seller doesn’t bother to borrow shares. Illegal naked shorting is intermingled with legitimate short selling in stock manipulation schemes. Throughout the 1990s and into the 2000s as the paperless system evolved, there were ever growing complaints about stock manipulation using both legal shorting and illegal naked shorting.

This led to the passage of Regulation SHO in 2005 which was intended to stop illegal naked shorting. However, this legislation has more holes in it than Swiss cheese and did almost nothing to control illegal naked shorting. Each year since Reg SHO was passed, the attacks have become broader, larger and more brazen. Here are some of the key aspects of the DTCC and Reg SHO that are exploited by short sellers:

• The dematerializing and demobilization of registered securities through DTCC’s Cede subsidiary meant that short sellers were now dealing with a commodity that was much easier to borrow and manipulate than registered shares.
• In the era of physical stock delivery, if a short seller wanted to borrow registered shares, they would have to locate a lender and negotiate a specific contract. The DTCC’s net continuous settlement system allows brokers to lend from inventories of stocks held by their clients, obviating the need to find a specific person or entity who will lend stock for shorting.
• Reg SHO allows “bona fide” market makers to naked short stocks without finding a lender for as long as six days.
• The clearing and settlement system process of the DTCC processes a buy and corresponding sell order from a short in two separate and split transactions. It guarantees both parts of the transaction. If a short seller cannot deliver borrowed stock at the settlement date, the DTCC assumes liability and completes the transaction on its own. As explained in detail in previous blogs, this can create counterfeit shares.
• The SEC has all the appearance of a captured regulatory agency that has shown little or no interest in combatting illegal naked shorting. The agency has openly defended short selling and naked short selling as increasing liquidity in the market and some top agency managers have said that hedge funds are the policemen of the stock markets, protecting investors against stock manipulation. Hmmmm. The SEC is a prime example of a regulatory agency being captured by the industry it is supposed to regulate that has turned a blind eye to stock manipulation fueled by illegal naked shorting.