Chanos And The “Giant Positive Reinforcement Machine”

Chanos And The “Giant Positive Reinforcement Machine”
Jim Chanos photo via <a href="" target="_blank">Insider Monkey</a> (CC BY-ND 2.0)

Jim Chanos did an interview with Yale’s Alumni Magazine September/October issue. In the interview, Chanos talks about some of his biggest bets, the structure of the market, and the course that he teaches at the prestigious university. Chanos has been teaching financial fraud for three years to Yale’s best and brightest.

Chanos And The "Giant Positive Reinforcement Machine"

One of the most interesting parts of the interview concerns Chanos’s general opinion of the stock market, and its relationship to his business of shorting. Chanos calls stock markets “giant positive reinforcement machines.” That makes shorting stock unnatural, and almost obscene in the eyes of the rest of the market.

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Chanos and the nature of shorts

Chanos has a lot to say about the general philosophy behind shorting stock in the interview. The giant positive reinforcement machine of the market is designed to sell stock. That makes everything bullish and means that shorting stocks is a bad idea, unless the investor is very careful.

In order to operate successfully as a short seller, an investor needs to be able to hold to their convictions and ignore everything the market is telling them. If everybody knows a stock is bad, a short seller has no opportunity to make money. A short seller needs to get in when the price is high and positive reinforcement reaches its peak.

The ability to keep your head when all around you, people are losing theirs is the prime attribute of a short seller. Chanos has that ability in spades and it has guided him through the big victories and the painful defeats. Many of Chanos’ adventures are detailed in the YAM piece, but his Chinese campaign is probably the most interesting.

Shorting China

Chanos has made several comments about the financial stability of China in the last year. The hedge fund manager believes there’s a credit bubble in China, and he’s actively betting against the country. Chanos thinks the bubble has the ability to hit commodities and businesses all over the world, along with the Chinese credit market.

The commodities “supercycle,” a more than decade-long period of growth in commodity prices as demand from China continued to increase under the weight of the country’s economic growth, is coming to an end according to Chanos. That means almost all of the world’s commodities could be in for a fall in price in the medium term.

Chanos has said that he earned money betting against huge swathes of the Chinese economy in the last year. According to his public statements, he’s earned money in the steel sector, real estate, and the financial sector. The manager has admitted that his initial predictions about the Chinese economy have not come through, but he still expects a collapse in Asia.

Chanos originally predicted a huge credit crunch caused by the real estate bubble, a shadow banking system, corruption and lack of central control over markets. China is now actively trying to soften that bubble.

Chanos admits that his initial prediction about the economy was incorrect. He still thinks the Asian giant is going to see declines in growth ahead. The giant positive reinforcement machine is still talking up most of the Chinese market.

Chanos says that China is “on an economic treadmill to hell.” So far, his predictions about the country have not panned out, but those shorting whole economies need to be patient. Chanos is able to ignore the positive reinforcement machine.

In this case, however, the positive reinforcement machine might be right. That is always the risk that the short seller takes. Chanos is used to the pressure.

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