short selling as an investing tool (I)

Yesterday I argued that there’s a long-term tendency for the stock market (in any country outside Japan) to rise.  There are two reasons:

–national monetary policies are set up to avoid deflation by encouraging mild inflation, so nominal prices generally rise; and

–at least some people aspire to economic gain, or to creating new products and services, so in the absence of government policies that discourage these activities, real GDP also tends to rise.

Where does this leave short selling?

As it turns out, my first portfolio job–after four years as an analyst–was (luckily for me) working for an extremely skilled investor on a short portfolio.  So I know a little about the subject.

I’m going to write about this topic in two posts.  Today’s will cover the basics.  Tomorrow’s will be about hedging techniques used to control the substantial risks that shortsellers take on.

why professionals find shorting attractive

Two factors make short selling theoretically attractive, even in a world where stock prices generally rise:

creative destruction:  Often, the rise of a new product or service sounds the death knell for an older competitor who is unwilling or unable to adjust.  Specialty retailers began to replace department stores in the move to the suburbs thirty-five years ago.  They are being supplanted now by on-line commerce, as well as by the reemergence of more flexible generalists like WMT and TGT.

less competition:  Most professional investors gravitate toward the long side and toward fast-growing new industries.  As a result, there may be four or five sharp minds looking at every long idea for every one looking at a short.

why it’s not for everyone

1.  I think shorting is harder than buying a stock you think will go up.  The long side has many types of specialized investors.  For instance, there are large cap and small cap specialists, value investors and growth investors, special situation investors.  For a stock to rise, one of these groups has to like it.

But for a short idea to go down, everyone has to dislike it.  Not only do you have to have a certain quirky turn of mind (a kind of Schadenfreude) to be a successful shortseller.  You also have to be able to put yourself in the place of groups with different parameters for what makes a good stock and think out why your potential short won’t interest any of them.

2.  It’s riskier to short stock than to be a buyer.  When you short a stock, you borrow shares from someone else and sell them.  You  hope you can buy them back later on at a lower price, so that you can return them to the original owner and close out your position.

In the meantime, you have to post collateral, which is held by a third party.  The amount of the collateral needed to support the short position goes up if the price of the stock you’ve shorted rises–sort of like margin debt in reverse.  Two implications:

–you can be absolutely correct, but being early, with an insight that runs counter to the mass mind of the market, can be a killer.  Suppose, for example, you thought MSFT’s best days were behind it at $35 a share in early 1999 and shorted it then.  You would have been right on a two-year view.  But in the intervening time the internet craze drove the stock up to close to $60.

It would have been an even more testing experience if you thought PMC Sierra (PMCS–now a $8- stock) was over valued at $50 in late 1999.  Again, you would have been right on a longer-term view.  But that stock, smaller and zippier than MSFT, flirted with $250 a share both in early and in late 2000.

Yes, PMCS and other internet-related chipmakers were unusual cases.  But the fact remains that in any short you run the risk of running out of collateral and having to cover your position at a substantial loss before the world realizes you’re right.

–a related risk, though more of a worry for professional shortsellers than for you and me.  Your broker can change his mind about your creditworthiness and increase the amount or type of collateral he requires.

That’s it for today.  Hedged vs. unhedged shorting tomorrow.

more on absolute vs. relative performance

One of the earlier posts I wrote on this blog had to do with absolute vs. relative performance.  I reread it today and am generally satisfied with what I wrote then.  One exception, though.  I think the post came at the topic from the rather narrow perspective of a professional investor, who is already convinced that the best way–or at least one good way–to achieve absolute performance is to try to achieve relative results.

In this post, I’d like to broaden my discussion of the topic by adding two observations, one psychological, the other economic:

1.  One of the most important of the (many) clichés Wall Street uses is that market turns, especially upturns, come out of nowhere and catch most investors by surprise.  Not only that, but the initial move up can cover a lot of ground in a short time.  Missing this initial surge, so the argument goes, is virtually impossible to recover from.  Brokers typically cite academic studies that the greatest part of the market’s gains over a business cycle come in only about 10% of the trading days.  Be out of the market on those days and you’re toast.

I think there’s something to that argument.  I’d like to add my own twist to it, though.

In my experience, lots of professionals can either tell when the market is getting toppy or when it’s stunningly cheap.  But I don’t know anyone who has been able to do both.  Wall Street is a very gossipy place, so if there were such a person, word would get around–despite the individual’s desire to keep his ability to time the market a secret (so others wouldn’t begin to study his every move and his skill would remain his edge alone).  In addition, just off the top of my head I can think of three former professional acquaintances who “called” the top of the market, one in 1984 and two in 1986, with disastrous results for both them (two were fired) and their clients.

Look at the record of hedge funds, whose aggregate performance failed to match that of the S&P 500 every year since 2003.

Anyway, I think some investors have bearish temperaments and can call tops but not bottoms.  Others, like me, have a bullish cast of mind.  We can call bottoms but not tops.

2.  Assume that we live in a world that’s characterized by:  a) inflation; and b) economic growth.  Each implies that stock prices will tend to rise.

a.  Modern economics comes out of systematic study of the Great Depression of the 1930s.  One of the highest goals of monetary policy around the world is to avoid a recurrence.  In particular, the world wants to avoid a repeat of the deflation that marked that period.

Other than in the case of Japan, which has consistently chosen to have deflation rather than permit structural societal change, the world has been successful in doing so.  Let’s suppose (and fervently pray) that this continues.  What does this mean for stocks?

Stocks are priced in nominal terms, in dollars of the day.  But they represent ownership claims on real assets and business operations.  Inflation means that nominal prices in general are rising.  So there should be a tendency for the nominal value of the corporations whose shares of stock are publicly traded to rise as well.  Ultimately, this should translate into a tendency for stock prices to rise, even in the absence of real economic growth.

b.  But, as an empirical observation, there’s real economic growth all over the place.  The US economy, which has been closer to the caboose of the world economic train than the locomotive, is still 50% larger than it was a decade ago.  New nations have entered world commerce.  We have notebooks, netbooks, tablets, iPhones, iPods, social networking, online shopping, biotech, medical advances–lots of stuff we didn’t have ten years ago.  Why?  …because many people around the world like to build and invent new things.  Publicly traded firms–where else do entrepreneurs get the money they need to grow their companies–participate very substantially in this growth.

My point is that the path of least resistance for stocks–due to inflation and to real economic growth–is up.

Yes, I believe what I’ve just written is true.  Maybe it’s a cartoon version of the truth, but it’s true.  That’s not really what I’m trying to convey in this post, though.  What I want to say is that professional investors in general opt to try for relative performance rather than absolute because they believe this, too.

China: the US is dumping its chicken feet in our market!


what dumping is

Dumping involves selling products in an export market.  Two conditions have to hold for sales to be dumping:

1.  the selling price must be below some concept of “fair value.”

Typically, this means the selling price abroad is lower than the selling price in the home market.  Alternatively, the country where the products are sold may claim the selling price there is below the manufacturer’s (average) cost of production–even though it may be the same as, or higher, than the selling price in the home market.  The “cost” is usually figured by the export country’s regulators.  That may be a lot higher than what’s shown on the financials of the manufacturer.  Historically, the US has been regarded as a master at ending up with a high number.

2.  the sales have to be shown to be doing damage to local industry participants in the export country.

special China-only ” safeguard” provisions

As one of the conditions for its joining the World Trade Organization, China had to agree that an increase in sales volume over stated limits would count as dumping during a number of transition years, even if conditions 1 and 2 above weren’t satisfied.  The rationale was to allow local industry participants time to adjust to a world with competition.

tires and chicken feet, a year ago…

As I outlined in a post when it happened a little over a year ago, President Obama invoked the “safeguard” provision regarding low-end auto tires produced in China and sold in the US.  There was no economic reason I can see for doing this.  It was purely back-room politics, a favor for the United Steelworkers union.

China responded by taking the first step in the WTO dispute resolution process.   It placed tariffs with equal revenue impact on imports of chicken feet (and to a lesser extent, wings) from the US.  At the same time, it opened an anti-dumping investigation of American chicken parts.

…and now

Over last weekend, Beijing released the findings of its chicken feet inquiry.  Yes, dumping has occurred (no surprise here–you can’t give away domestically all the chicken feet the US producers.)  Duties of between 50% and 105%, depending on the breeder, will be imposed for five years.

While presumably technically correct, the decision appears to be as economically self-wounding as the Obama decision a year ago.  Why?

Americans like white chicken meat.  To meet demand, US poultry companies breed chickens with gigantic breasts.  The chickens also have to have enormous feet and legs so they don’t topple over.  America doesn’t want all the feet breeders grow;  they’re more or less a waste product.  But they’re a delicacy in China, whose importers will reportedly pay up to 20x what the feet would fetch domestically.  (I’ve eaten chicken feet once or twice in Hong Kong and New York.  For what it’s worth, I don’t get the appeal.)

The result of the tariffs:  food costs go up in China; Chinese eat more of their skinny domestic chicken feet; American poultry producers, who should be allies of China in Washington, make less money; and the treasury in Beijing has more income–just what it needs.

there’s a deeper game afoot (as it were)

In other times, this situation would be pure comedy.  But, although I think the chances of truly damaging trade actions are slim, I don;t feel they can be completely ignored, as one would have done in the past.

From the US side, both parties in Washington appear desperate to find someone–anyone–other than themselves to blame for their poor stewardship of the US economy.  Moderation also seems to be in very short supply.  In addition, companies that sell Chinese products in the US–meaning just about everyone– are less vociferous inside the Beltway in their support for China, given recently announced limits on their ability to expand their operations in the Chinese market.

For its part, C

hina has been slow to recognize how big a burden it is putting on a country with a quarter of its population through the peg between the renminbi and the US dollar.  It has no reservoir of good feeling or obligation to the US, based on WWII and its aftermath, either.  Quite the opposite.  It is acutely aware of the Opium Wars and other abuses of the “Great Powers” of the nineteenth century–in which group it includes the US.  And it believes it is a major victim of the US financial crisis.

It’s not clear, to me anyway, that either side really understands the other’s position.  In the case of the US, I’m confident Congress is completely in the dark.

As a result, I worry that there’s some small chance that one side or the other will accidentally move the politics of trade beyond the only marginally relevant into areas where real economic damage can be done.  I don’t think this is likely, at this point,or even that this possibility should be factored into portfolio composition for anyone.  But for the first time in at least a decade, I think this is a situation to be thought about–in terms of what action to take if events take a turn for the worse–and monitored.



A big new step toward the “Internet of Things”

About a decade ago, someone in the RFID-tag community coined the “Internet of Things” phrase.  The idea is that the ultimate destiny of the Internet is to be a communication and coordination network, not primarily of people, but of devices–from appliances, to houses to cars…–talking with each other through imbedded chips.

Today, that idea is sounding less and less like science fiction.  During the June quarter, major US wireless networks reported that they hooked up more new devices (such as digital picture frames and internet-enabled TVs) than new people to their networks.  Maybe not such a surprise, given that the US is already 100% penetrated with cellphones.

Another step came last Thursday, when the FCC issued an order allowing the use of wi-fi-like devices over the “white space” frequencies that separate TV channels and are intended to prevent interference.  This is intended, in the words of the FCC press release,  to “unleash a host of new technologies” that include things like:

–home wi-fi without dead spaces,

–“super wi-fi,” that is, long-distance, wide-range wi-fi that should allow inexpensive blanket wi-fi coverage of large areas, like ports or other large distribution hubs, as well as extending wireless internet into sparsely populated locations.

This action opens the door for all sorts of “intelligent” device applications.  Devices and services–like appliances with chips in them that can coordinate their actions (adjust the heat, wake you up earlier is there’s traffic congestion…)–should in theory be available by early 2012.  IBM posted its ideas on what the Internet of Things will be on You Tube in March.

There’s still a big issue to be faced , however–net neutrality.  At least some of these wi-fi networks will be built by companies.  Will these be private, or will non-affiliated service providers be entitled to offer their wares on it, even though they have not contributed to the network’s construction costs?  This is the question that GOOG and VZ raised in an oblique way in their “Legislative Framework Proposal” in early August.

To me, it sounds like GOOG and VZ are willing, even eager, to build out “super Wi-Fi” networks and offer new services on them–provided they can either deny access to other potential service providers or give them lower priority on the new systems.

This implies that the development of really revolutionary new services will depend on the FCC clarifying the ownership issue for new commercial Wi-Fi networks.

investment implications

A favorable FCC decision for GOOG and VZ on Wi-Fi network ownership would likely be a big plus for both companies.  In the absence of that, the significant winners–and the safest stock market plays, in any event–will be the chip makers that will supply demand for new-standard Wi-Fi chips.

Japan’s curious currency intervention

This is an update on my recent post about the sharply appreciating yen.

About a week ago, the Bank of Japan intervened in the currency markets.  It reportedly spent about $20 billion in a (so far) successful attempt to depress the value of the yen against the US dollar.  And as the dollar began to give back some of its 4% gain against the Japanese currency this past week, in response to the Fed’s indication it hasn’t ruled out further quantitative money easing, the BOJ is hinting it may not be done.

Experience and financial theory both tell us that intervention can do no more than buy a little time for a country to implement structural change.  But Japan shows no signs, to me anyway, of wanting to reverse its stance that preserving a traditional social order is its preferred alternative, even if it involves economic senescence.  So the money spent on currency intervention is ultimately wasted.  The BOJ certainly knows this.

The move wins Tokyo no friends in Washington, which is trying to pressure China into allowing the renminbi to rise.

Why intervene, then?  I think it’s an issue of partisan politics.  The Democratic Party of Japan was swept into office last year in a mandate for change from the corrupt money politics practiced by the Liberal Democrats. This shows voters’ extreme dissatisfaction with the LDP, since one of the DPJ’s leading lights is Ichiro Ozawa, who has long been associated with back-room money politics.

Having somehow escaped involvement in a recent corruption scandal that forced then-Prime Minister Hatoyama to resign, Ozawa decided to emerge from the shadows and challenge the new PM, Naoto Kan, for leadership of the DPJ.  Ozawa was resoundingly defeated.

I think the intervention was the price Mr. Kan had to pay to sway the votes of JDP party stalwarts in the Ozawa faction.  The timing of the intervention is one reason I’d cite in support of my opinion.  The second is the willingness of the BOJ, an independent body, to go along with an ultimately futile gesture.  However odd the present DPJ government, it’s certainly better than an Ozawa-led one–or a return to the LDP.

The BOJ has supposedly drawn a line in the sand at $1 = ¥ 82.  The parties seeking to push the yen higher are supposedly not the major global commercial banks but Japanese individual margin players.  If so, further substantial intervention may not be needed to maintain the status quo.  After all, the government can always tighten margin requirements.

From an equity investment point of view, however, the fact that the value of the yen is not front-page news shows how far into irrelevance the Japanese economy has fallen.  To my mind, Tokyo is now a special situation market, driven by smaller counterculture” firms.  They actually benefit from a stronger yen.