Short Sellers and the Role They Play in the Market

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Short Sellers and the Role They Play in the Market

When politicians don’t have answers, they blame speculators, financiers (Wall Street), or foreigners.  They do anything to take the spotlight off their culpability or ineptitude.

The above saying is similar to the idea that when a company blames short sellers, it is usually a sign that the short sellers are right, and the company is mismanaged.  Think about it: when a short seller builds a short position, someone else is building a long position.  The borrowed shares that are sold have to be sold to someone.  Also note that the shorting does not change the cash flows of the company. Even the dividends don’t change because the shorts pay dividends to the extra shares.

The shorting is a side bet on a greater question: will the company be able to produce free cash flow adequate to justify the current stock price?

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What applies to companies also applies to nations.  During a debt crisis or a currency crisis, there will be an appeal against speculators that are shorting the debt.  Well, guess what, for every unit of debt shorted, there is another party buying the debt.  This applies to credit default swaps as well – on the other side of the trade there is a guy saying, “What a nice yield.”

The politicians complain, but they could fight back: they could buy in their debts and squeeze the shorts.  What’s that, you say?  If they did that, they would either have to raise taxes or cut programs?  And that is anathema?  Well, then the shorts aren’t to blame.  The government is to blame; it has made its own bed, let them sleep in it.

After all, shorts target companies that are mismanaged; they have no free cash flow, and can’t fight back.  The same for nations that are mismanaged; they have structural budget deficits, and a political culture that won’t change it.  No surprise that the shorts show up.

The shorts don’t change anything; they recognize a fundamentally weak situation, and locate a stock lender and a dumb buyer.  Same thing for a bond lender, and a dumb buyer as far as countries or deeply distressed companies are concerned.  And all of this can occur via derivatives if this is the best manner of doing the trade.

In the end, only free cash flows matter, and companies with large free cash flow never have to worry about the shorts.  Same for nations that have their budgets in accrual balance.

By David Merkel, CFA of alephblog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.