Short Sellers Need a New Playbook for Picking Stocks
(Bloomberg Opinion) -- Last month's historic rally in heavily-shorted stocks wasn't just about Reddit, Robinhood and GameStop. It may also have had something to do with the Georgia Senate runoffs.
The impact of two additional Democratic senators on the prospects for fiscal policy and economic growth may have crushed the strategy of selling short the stocks of companies that struggle in an environment of slow economic growth — at least for now. A basket of stocks that might have struggled in an environment where economic growth averaged 2% to 3% a year might do just fine if growth is going to average 5% or more, as economists are forecasting for this year. With Congress looking to spend trillions of dollars to boost the economy, short sellers might need a different playbook to be successful.
What works for short sellers changes based on the overall market environment. In the early 2000's it was selling short the stocks of overvalued technology companies, as well as companies like Enron Corp. with deceptive accounting practices. Later on in the decade, the targets were companies tied to the housing and credit markets. And of course Michael Lewis wrote a book titled The Big Short based on the credit derivatives trade that caused so much consternation in markets.
Over the past decade, the most consistent theme for short-sellers has been betting on the losers from technological disruption, whether they be brick-and-mortar retailers, who have lost market share to e-commerce companies; oil and natural gas producers, who are losing share to renewable sources of energy; and the traditional financial services industry, which has had to fend off new financial technology companies like Square and PayPal while cutting fees and struggling with low interest rates.
All of those bets amounted to wagers on slow economic growth. When growth is a lot faster, shrinking retailers become stagnant-but-stable retailers, oil-and-gas companies benefit from at least a temporary increase in energy prices, and banks gain from higher interest rates and loan growth. The GameStop squeeze may have been the move that made national news, but these heavily-shorted stocks had been rallying for awhile as faster economic growth was getting priced in with the advent of Covid-19 vaccinations and political momentum for additional fiscal stimulus.
Part of what can make a short squeeze so epic when the growth environment increases is the amount of operational and financial leverage a struggling company often has. A way to think about this is to compare a leading brick-and-mortar retailer like Walmart Inc. with a struggling one like Macy's Inc.. A 2% rise in revenues for both companies thanks to a faster overall growth environment might mean modestly higher profits for Walmart, while for Macy's it could mean the difference between a modest loss — and the slow path to bankruptcy — and a modest profit, which can then be used to reinvest in the business or pay down debt.
For struggling companies like Macy's, debt is often substantial, with high interest rates to go along with its riskiness, which makes addressing the debt more difficult. As the company's fortunes turn around, its investors get more optimistic on the company's prospects and its corporate bonds often rally in price, giving the company more flexibility to address its troubled finances.
Reddit and Robinhood investors aside, as vaccinations in the U.S. increase to a pace close to two million per day, and as Congress works through a fiscal relief package close to $2 trillion in size with the possibility of another trillion-dollar infrastructure package later in the year, the economic growth environment is likely to be so robust for awhile that even bad companies will reap some windfall profits for a while. That makes shorting stocks based on slow economic growth a dicey proposition.
What's needed is a new playbook. Maybe that means taking a skeptical eye to the dozens of newly-listed companies that could struggle to adjust to being publicly-traded. Should faster inflation materialize, that could be a problem for some companies and offer a shorting opportunity that investors haven't seen in a while. Maybe the effects of fiscal stimulus will wear off later in the year, giving short-sellers an opportunity to redeploy the slow-growth playbook in 2022.
But as long as we have historic levels of economic growth combined with historic levels of fiscal and monetary stimulus, as we're likely to have for much of 2021, short-selling probably needs a rethink. The entire policy apparatus of Washington is committed to making sure that bets on slow growth fail.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Conor Sen is a Bloomberg Opinion columnist and the founder of Peachtree Creek Investments. He's been a contributor to the Atlantic and Business Insider and resides in Atlanta.
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