Short-selling fell out of favour during the long bull run in equities and fixed income that took off following the Great Financial Crisis. The easy-money policies pursued by global central banks created a rising tide that floated all boats, according to a former governor of the Reserve Bank of India. Back in 2018, Raghuram Rajan asked presciently, ‘When the tide goes out, will we find out who’s been swimming naked?’ Short-sellers have been finding plenty of skinny dippers since the beginning of 2022, and that trend looks set to continue.
A new golden age for short-selling?
Higher borrowing costs bring new targets into view
Short-sellers have experienced slim pickings over the past decade amid surging global stock markets. Apart from the odd sell-off – such as during the taper tantrum of 2013 and the outbreak of the pandemic – stocks have only headed upwards since emerging from the global financial crisis.
Cynics even coined the phrase ‘the everything bubble’ to describe a market in which shares, bonds and real-estate prices all rose sharply on the back of ultra-low interest rates and purchases of bonds through quantitative easing (QE) programmes. Those policies kept the flow of speculative cash going, but that era could now be over as surging inflation triggers a reversal in monetary policy.
Equity and bond investors certainly nursed significant losses in 2022. The 10-year Treasury yield soared above 4% after starting the year near 1.5%, crushing most bond portfolios, while global equities, as measured by the MSCI World Index of global equities, fell by 15.6% in dollar terms. There has been little let-up in 2023, with bonds and equities experiencing considerable turbulence as markets try to balance growth and inflation data with the outlook for interest rates.
The return of volatility has been a boon for short-sellers, with the huge sell-off in the technology and crypto sectors, in particular, providing a wealth of opportunities. In 2022, total profits amounted to around $300 billion in mark-to-market profits, on average short interest of $973 billion, according to S3 Partners.1
There’s little wonder that the Financial Times (FT) has asked if a ‘new golden age for short sellers’ has arrived.2 The publication argues that ‘higher interest rates have ratcheted up the pressure on firms whose business models rely on access to cheap debt while they also make the projected future cash flows of high-growth but unprofitable tech companies less attractive’.
Figure 1: The performance of short holdings over the past five years
Aggressive accounting techniques
Meanwhile, Muddy Waters Capital, a Texas-based hedge-fund manager founded by short-seller Carson Block, believes that since the 2007-08 global financial crisis, companies have pushed aggressive accounting to its limits. While most of the companies he investigates haven’t done anything illegal, they have exaggerated their value and that could create opportunities for short-sellers.3
Higher interest rates also benefit short-sellers in other ways. Citing Goldman Sachs data, the FT explains that higher rates mean the interest earned on the cash short-sellers deposit with a broker until the trade is completed outstrips the cost of borrowing the shares. Thus, they can generate a profit even before any gains on the particular bet itself are made.
The good times for short-sellers have continued in 2023. A number have profited from shorts on the collapsed bank SVB, stricken Credit Suisse and the scandal-plagued Indian conglomerate Adani. However, the dangers inherent in short-selling have also been highlighted. An equity rally at the beginning of the year caught many hedge funds by surprise, forcing the largest overall retreat since January 2021, when day traders co-operated on Reddit to take on professional short-sellers.4
Thematic bets
Nevertheless, the overall outlook for short-sellers in 2023 is promising. Uncertainty about the path of inflation and interest rates is likely to continue for some time, leaving markets to gyrate on any data surprises. Then there are plenty of thematic short strategies in play. In March, for example, Bloomberg reported that a hedge-fund manager who made a 119% return shorting debt linked to shopping malls ‘is betting on fresh pain in the US commercial property market’.
The news agency quoted Daniel McNamara, founder of Polpo Capital Management, as expecting a large number of older offices to fail to lure back workers in the post-Covid era, making them less attractive to occupiers and spurring a wave of defaults. McNamara was quoted as saying:
‘We think there’s a lot of room for this thing to fall in the short term. And in the longer term, at maturity, they’re going to be worth a lot less.’ 5
Bloomberg highlighted that the strategy used by Polpo and other hedge funds betting on a fall in demand for less-desirable workplaces – older buildings or those in unpopular locations – ‘will render big swathes of the office-property market obsolete and loans linked to them at risk of delinquency’. The hedge funds are using derivative indexes that track the performance of commercial mortgage-backed securities.
1 https://www.cnbc.com/2023/01/05/traders-who-bet-against-stocks-made-a-killing-in-2022-as-short-sellers-netted-300-billion.html
2 https://www.ft.com/content/a8e93c07-d084-4396-9aa9-76515686e3be
3 https://www.ndtv.com/business/for-short-selling-hedge-funds-2023-is-full-of-rich-pickings-3611904
4 https://www.bloomberg.com/news/articles/2023-02-06/hedge-funds-cut-bets-in-largest-unwind-since-2021-short-squeeze
5 https://www.bloomberg.com/news/articles/2023-03-09/hedge-funds-bet-against-offices-using-tactics-that-big-short-s-burry-made-famous
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