Short sellers are making an even bigger killing than you think

JAN 21, 20162:18 PM

[MADRID] Last year was the most profitable ever for short sellers, by one measure. And 2016 is starting off even better for bears.

It's no secret that betting on declines is proving profitable in what has been the worst start to a year ever for global stocks. What is surprising, according to research firm Markit Ltd, is that returns for shorts are even higher than those generated during the 2008 financial crisis, when considered on a relative basis.

Back then, it was the housing bubble and the collapse of the banking industry. Now it's China, oil and the end of zero- interest rate policy in the US Sustained worries about an economic slowdown and the rout in commodities has added momentum to short strategies into the end of last year, with shorting activity peaking in the closing weeks of 2015 and showing no sign of slowing, Markit said in a report last week.

"Over the last five, six years, you've been conditioned to use weakness as a buying opportunity, and when other people are scared you've been paid to be brave," said Michael Shaoul, head of Marketfield Asset Management LLC, where he co-manages a US$2.4 billion long-short fund. "At this point in the cycle, weakness needs to be treated at face value. When one sector starts to deteriorate, there's no reason to expect it to get better." In the US, Markit found, the most hated stocks - the top 10 per cent most costly to short - underperformed the market by a record 26 per cent in 2015. In 2008, they trailed by 19 per cent. Those shares are now on track for the worst month ever - or the best ever, from a short seller's perspective. Two weeks in, they're already trailing the market by 6.7 per cent.

Giving an extra boost to shorts this time around: the widest split between winners and losers since the 1990s, a commodity rout that made shorting related stocks a no-brainer, and an unprecedented era of cheap debt that could come back to haunt overlevered companies. Favourite shorts, Markit says, include Chesapeake Energy Corp, Peabody Energy Corp and Sears Holdings Corp.

Compared with 2008, when the Standard & Poor's 500 Index plunged 38 percent in a broad selloff, the market last year was more fragmented. Even as the benchmark slipped 0.7 per cent, the average decline in the 10 worst stocks was 64 percent, while the 10 best surged 71 per cent, according to data compiled by Bloomberg. Amazon.com Inc and Netflix Inc were among star performers that more than doubled.

"It might as well have been 2008 for commodities and 2000 for technology," Mr Shaoul said.

This year, the S&P 500 has lost more than 10 percent as stocks around the world enter bear territories.

But market trends are just that - trends, says Robert W Baird & Co's Patrick Spencer. Betting on slumps in the same stocks and industries that did poorly last year may prove costly down the road, says the equities vice chairman based in London.

Still, the backdrop for shorts could hardly be better. And that's even without the added concern stirred by the Federal Reserve. The central bank's withdrawal of years of life support to the economy is a jolt not lost on any investor, long or short, says BGC Partners' Michael Ingram.

"If you were a bear fund during those years of QE you had massive problems," said Ingram, a market strategist at BGC in London. He has been bearish since early last year. "Now, the performance of shorts tells you that this juggernaut of momentum, supported by the idea that central banks have your back, is over. The game has changed."

BLOOMBERG