The shorting ban on financial stocks including Wesfarmers comes off on March 6th, unless of course it gets extended. The mere fact that the banks were so keen for it to stay on tells you how important they think it is to their share prices. In fact you might suggest it is artificially supporting the sector considering their concerns. Just what is shorting. Why is it important, and how is it done. I have been asking around. Here is a short guide to shorting in the current market.
- In a rising market the average trend is up which favours long only funds and in a Bull market shorting is understandably a small feature of the market because it is playing against the odds and the use of it negates the positive returns. We are only writing about it because it is a Bear market and it is party time for shorting.
- A Bear market is a Bull market for shorting capable funds and "fear" a much easier commodity to generate in a Bear market than optimism in a Bull Market. Fear can create radical share price falls, optimism has it limits.
- There are a lot less shorters than long only investors and to generate share price impact they therefore have to "focus" on individual stocks rather than "invest across the board". The game is to identify stocks in which fear is being generated and could be generated, given a nudge.
- Shorting is mostly done by institutions and not always just hedge funds. International institutions are more active than the average domestic institutions.
- Shorting is always better in packs. This has been the case since George Soros and his disciples took on the world's currencies. Collusion between shorting fund managers pays although no-one will admit it and no-one will be able to prove that it goes on.
- Private investors don't have the sophistication or firepower to execute shorting strategies alone, they have to identify what the major players are doing and piggy back.
Shorting and the ASX
- The ASX list of shorting which we have been publishing daily in Marcus Today is your best guide to watching the action. Look for stocks that appear day after day.
- Having said that there is a flaw in the ASX reporting of shorts because although you know clients have to declare if they are executing a short trade they don't have to declare if it is a covering trade. So you only see the shorts. Not shorts being covered.
- There are suggestions that although the ASX appear to be willing to police shorting and even discourage it the truth is that they are conflicted. When the shorting ban was on a lot of hedge funds, unable to short also stopped going long. They went to cash and stopped trading. That killed trading volumes, the lifeblood for the ASX. So there is scepticism about their simultaneous role as policeman and beneficiary.
Targets for shorting are stocks in which you can generate fear. At the moment that isn't too hard and your best targets are those companies with the following qualities:
- Weak balance sheets - debt.
- A refinancing around the corner.
- Cyclical stocks (least reliable future earnings and cash flows in the face of a global recession).
- Stocks that are hard to analyse (fear of the unknown easy to prod. Opaque stocks like investment banks).
- Growth stocks on high PE's. Easy to knock the fundamentals.
At the moment the biggest shorting commodity is fear of debt. Earlier in the bear market is was exposure to subprime, then the credit markets, then the economy. It will change again. Follow the themes.
The shorting cycle:
- Identify stock on the above criteria for maximum fear factor.
- Borrow stock and sell putting the price under pressure.
- Tell your mates.
- Drop the odd story about the balance sheet.
- Media picks up on the issues.
- Analysts prompted to look at the company by their dealers who are prompted by the share price fall and the media stories.
- Analysts highlight the weaknesses.
- Long only institutions start selling.
- Company bombarded with questions from analysts and media.
- Company doubt themselves.
- Company starts to squirm (announcements) opening Pandora's box on their debt structure.
- Company addresses issues with a plan to sell assets or have a damaging deeply discounted rights issue on a share price that has already been carted out and on multi year lows. Conclusion...it must be bad.
- Immediately after the institutional part of the placement is completed the long only institutions tip the stock back out for a profit driving the stock back down to the placement price.
- Shorting funds cover either by participating in the share issue or in the after market indigestion.
- Generally the rights issue will end the "attack" marking a low for the price.
How to combat a short attack:
Announce you have no debt issues and are not going to have a rights issue, exactly what RIO did last year, even though they may still have one. The short funds had to cover in the market in competition with each other as they doubted getting the Coup de Grace, which we have seen a lot recently, a deeply discounted rights issue.
How to make money out of shorting:
Learn how to short and learn to identify the targeted stocks.
Or...as a long only investor:
- Avoid buying the stocks that are targeted.
- Sell the stocks that you hold if they get attacked. You will get chewed up by shorting if you adopt a head in the sand buy and hold for value long term approach. All very well but you will be tested in the short term and as with RIO (fell 54% in 9 days) you are better off chucking in your long term ambitions and use the shorting to make money (taking the opportunity to buy more stock than you have lower down).
- Look to buy shorting victims for long term value when they are smashed (this isn't working yet because the market is still falling).
Bottom line - keep an eye on the shorting list we publish each day. If you are a long only investor watch out if your stocks appear repeatedly. If you are a shorter, jump on board and spread the bad news.
Other comments:
- The shorting ban on financials and property trusts and Wesfarmers comes off on March 6th. Assuming the market is still on the nose (helps to have the right market trend) the shorting funds will be lining up its targets.
- Shorting is within the law.
- Shorting can make a mockery of long only value investment in the short term. It has no respect for value or stockmarket puritans.
- Shorting is not long term, so if you are a genuine long term investor (are there any left) it creates opportunity.
- Shorting creates a lot of volatility and volume and attracts daytraders. But long only day traders beware buying the victims for a day trade where you start by going long. Odds are firmly against you.
Good luck on March 7th.
Marcus Padley is a stockbroker with Patersons Securities and the author of the daily stockmarket newsletter Marcus Today. For a free trial of the newsletter, go to http://www.marcustoday.com.au/