My tenth issue of Piranha Soup continues
the theme of the ninth version. It was focused
on rough times in fixed income, particularly
credit derivatives. Now I turn to rough
times in equities with an emphasis on
whether it is time to enter the short side
of the stock market. The madness of crowding
into the "credit, energy, Asia, emerging
markets" growth story will reach a
point of froth this winter. Below I make
a case for profit in short side beta and
Many will ask why I would focus on shorting
stocks when they are not expensive and in
fact are fair value relative to bonds. Economic
growth seems strong and on balance earnings
are holding up while the world is in pretty
good shape. I am adding shorts because there
is strong evidence that short side alpha
has bottomed, meaning it will become
easier to pick losers among companies.
As hedge funds, we are charging investors
to play two sides of the market and so,
if alpha is available, we are supposed to
go after it. Underlying this, I am bearish
on US stocks claiming that the corollary
to 2002 will hit this winter. Earnings
are about to break down. I believe those
funds that implement good shorting methods
will be those that have the buying power
in the next great bull market.
Section One: Why Short the Markets Now?
One of the worst strategies in the hedge
fund arena for the past 15 years has been
shorting companies indiscriminately as a
hedge. Those with a jihad against the market
due to fear are never rewarded. Also, recent
statistics show high levels of short interest.
For short sellers, the cost of borrowing
is expensive. Below I make a case for why
factors are now lining up to overwhelm the
bulls. I examine earnings, interest rates,
the housing bubble, and liquidity. The
analysis is largely a US analysis since
shorting is difficult outside the US and
since it is the US that is rolling over.
I have adjusted the charts and analysis
to give a different view than seen in most
If the market's PE is not overly
expensive, then I must make a case for
earnings to break. Let's start with
the simple fact that earnings make equity
prices tick. Earnings can be broadly predicted
by input costs such as energy and credit
and by output demand. This is a function
of how competitive the exchange rate is
and by the economic health of the buyer.
I have addressed credit cost as a whole
section below. Enough has already been
written about energy input costs but let
me summarise that in fact energy is not
the factor that it once was. It does not
need to be. It is making a negative contribution
on the cost side to a picture that is
already deteriorating on the demand side.
Turning now to demand, our central
focus is a US consumer that is stretched
and many technical indicators that show
this cannot continue much longer. While
others have focused on spending for
energy and interest as a percent of
disposable income, I choose to focus
on how long the consumer can take the
pain of overspending. The chart below
shows that for the first time in over
45 years, both consumer services spending
and consumer non-durable goods spending
are up as a percent of disposable income.
There is for the first time a positive
correlation for eight quarters. The
US consumer is spending on everything
and of course the source of this is
his credit cards and/or his second mortgage
on his house and/or reducing savings.
I will start with savings to determine
how long he can borrow from himself
before he must slow down spending.
as % of Personal Disposable Income
Source: BEA/Wolf International
The US consumer has tapped into his
savings like never before and this is
well known. What is less well known
is that the savings rate in relation
to the short-term interest rate is also
at extreme levels. The incentive is
to save but the consumer is not saving
due to the wealth effect of a housing
bubble and ready access to credit via
bad lending practices in housing. Below
is a compelling chart showing the 1-year
treasury yield minus the personal savings
rate. The chart measures the 2-year
percent change and therefore captures
the recent shift in interest rates.
The point of the chart is that I can
look all the way back to the 70's
and still not find a time when consumers
chose to have so little savings with
interest rates rising this much this
fast. Why does a consumer borrow
in the 00's when he did not borrow in
the real estate boom of the 1970's?
We know the answer is sloppy credit.
Yield on 1-Year Treasury
Minus Personal Savings Rate: 2-Year
Source: Federal Reserve/BEA/Wolf
This leads us to our next question,
when is the credit going to be taken
away. Starting with credit cards, the
new bankruptcy act in the US is requiring
higher minimum payments on credit cards
beginning 1 January 1 2006. Some banks
have already imposed these higher payments.
There is a doubling of the minimum.
Our math suggests this is not an overwhelming
burden, but it is another log on an
already burning fire. If my savings
are negative and my credit cards are
not available, that leaves my house
as a source of credit. The turning point
in the market is therefore a function
of the removal of sloppy credit practices
in housing. It is no wonder the Federal
Reserve is focused on this and is ratcheting
rates to cool it down.
The impact of a roll over in housing
is much greater than it appears on the
surface. Not only is it the main source
of debt growth, but employment in the
housing sector is way above trend. One
of my favourite managers tells me 3.7
million jobs will be lost if the housing
market reverts to the mean uptrend.
The losses are about equal in construction
and mortgage lending. This does not
account for the risk of a burst in the
bubble that moves those jobs below the
long-term trend. The housing market
in the US has now turned lower in critical
markets. Housing prices are falling
in some areas. Housing prices do not
need to fall everywhere to cause concern.
They simply have to stop going up so
much that they are a source of credit.
This process has now begun.
If stocks are fair value relative
to bonds, then I must make a case for
bonds to break. Most central banks
are now raising rates or are threatening
to. Rates may not go up much more globally
but they are going up and not down.
My readers will also recall that several
issues of the Sopa have stated we all
pay too much attention to central banks
and not enough attention to the interest
rates of real companies. Credit spreads
are still tight but have broken their
downtrend. Volatility has also shown
signs of bottoming. This normally coincides
with the bottom in default rates. All
signs point to higher costs ahead for
credit and the attending unwind of leveraged
plays on credit. The interest rate sensitive
parts of the US economy have begun to
roll over. All of this signals us to
lower risk. See the 9th issue of Sopa
for more details.
What about left tail risk? Prior
issues of Sopa have shown how correlations
are rising using a cross correlation
heat map (below). Even with economic
decoupling we are seeing high correlations
among markets. The evidence also shows
that correlation among hedge fund
strategies is the hottest it has ever
been. On the next page I show the
cross correlation of hedge fund strategies.
It is important to note how correlations
have risen through time. The current
heat map shows every strategy with abnormally
high "coherence". See the
7th issue of Sopa for details on coherence.
At the present time coherence is higher
than in the summer of 1998.
Heat Map: Aug 91 - Jul 93
Correlation Heat Map: Feb 01
- Jan 03
Cross Correlation Heat Map:
Oct 03 - Sep 05
Risk levels are very high for hedge
funds now because things are so good.
The market never rolls over when things
are bad. It peaks as the good times
peak. All of my indicators suggest this
is soon. The timing of this is very
hard to predict. Bottoms are easy to
find, everyone is in a state of panic.
The best guess time frame for a significant
top in the market is this winter (December
Section Two: How Has the Market Changed
If we are going to contemplate shorts, we
are forced to notice the changing dynamics
of the shorts side. There is a reason some
hedge funds are moving to long only. The
structure of the market has undergone monumental
change since the last time I wanted to be
short. To summarise, transaction costs are
down, the markets are more fragmented and
speed of execution has risen. This sounds
good except that the "tails"
in small companies are full of crowded shorts.
Below I look at the changes in some detail.
What are the changes specific to
equity trading in the last five years?
There are more short sellers than ever.
Below I show the absolute level of shorts
just in specific NASDAQ equities. This
does not of course include exchange traded
mutual funds (ETFs) and other shorting
methods. While the absolute amount of
shorts has tripled in ten years, the totals
are still tiny. There is no evidence that
there are too many shorts or too much
short interest overall.
In addition to more shorts, the market
is increasingly fragmented. In 1997,
the SEC began to permit equity trading
in alternative trading systems (ATS).
The result was the electronic communication
network (ECN). Market makers were cut
out and today over 50% of trading in
NASDAQ listed stocks is done "off
exchange". This caused margins
to collapse and some chaos ensued. More
recently the market created what is
effectively a consolidated limit order
book (CLOB) to consolidate all trading
information in one place. By 2001, decimalisation
was also introduced further reducing
the cost of a trade.
Since the size of the quotes was reduced,
liquidity for institutional investors
at the quoted level was also reduced.
For those so inclined, it also became
cheaper to step in front of big orders
and to meet up tick rules. The outcome
of all of these changes was a need to
feed orders in smaller blocks through
all available liquidity sources. This
vicious cycle led to a drop in the average
trade size from 1500 shares to 300 shares
in five years. The next shoe to drop
is the elimination of the up tick rules
which is already being tested.
In June of 2006, regulation NMS is
planned. This makes it illegal to execute
a trade at a worse price than is available
elsewhere. This will force a reconsolidation
and instantaneous communication. The
bottom line is that exchanges are going
electronic and we all will have the
same execution and information. Clearly
this process has taken away the easy
edge of professional shorting. Hedge
funds are now forced to do original
work and find bad companies. One might
also conclude there are more opportunities
for shorting in other countries.
Dollar Weighted NASDAQ
Short Interest as of % of Dollar Shares
Source: Wolf International/NASDAQ
A second major market change is
that short sellers are using more indices
and ETFs. Simply put, hedge funds
are hedging and not shorting companies.
This explains why short side studies
in hedge funds suggest the alpha is
negative. It is a pure cost. Shorts
in ETFs now represent as much as 50-75%
of trading in some markets. The amount
of shorting has tripled in recent years
in ETFs. This heavy shorting of indices
also explains why index volatility is
less than individual stock volatility.
Heavy two-way trading in these indices
is compressing market movements, at
least for now.
Historic Cumulative Dollar Short Interest
as Fraction of Total
Source: Wolf International/NASDAQ
The chart above shows the shorting
of the top 100 NASDAQ stocks since 1994.
It measures the cumulative dollar short
as a percent of the total to show how
large stocks are being shorted versus
small stocks. It shows that shorting
in the smaller stocks as a percent of
the total is rising far more than in
the larger stocks. This is what you
would expect with index shorting of
a cap weighted index. Short sellers
are now shorting all stocks and the
smaller ones are being shorted more
as a percent of total shorts. The cost
of borrowing these stocks has gotten
A third market change is that short
side attribution is negative even for
those hedge funds that are trying to
select bad companies. This is almost
certainly due to crowding. As I researched
this Sopa, I spoke to many funds about
their shorting. These were both short
sellers and long/short funds. Many complained
of negative attribution. We were able
to get (though not publish) information
showing that some of the world's best
managers make more than 100% of their
short side gains on companies that go
near zero. What seems clear is that
shorting stocks to make money from lower
prices is a losing game even if beta
is excluded. The managers that make
money locate companies that are going
to implode so that the stocks approach
Below I show this graphically. The
NASDAQ is once again used but this time
with all members of the composite. The
colours show the percentage of short
interest in those stocks. The small
ones are clearly being heavily shorted
and increasingly so since 1994. There
were few shorts in these stocks until
2003 and now many of them have more
than 20% short interest. It is no wonder
they are hard to borrow. Small companies
are more likely to go broke and so it
is expected that the shorts are concentrated
there. Those funds doing original work
are finding the right shorts and not
the crowded shorts being touted by the
Stock Specific Short Interest Percentage
At the beginning of this Sopa, I mentioned
that short side alpha was going to improve.
In fact it has improved since late 2003
when alpha was at its negative peak.
During 2003 bad companies moved higher
in sympathy with the general trend.
More particularly, high earnings leverage
at that time meant any economic improvement
fell to the bottom line. In the 4th
issue of the Sopa, I focused on improving
equity alpha from four sources. These
were normal volatility, stable economic
indicators, geographic decoupling, and
individual market/equity dispersion.
In fact volatility fell from abnormal
highs to its abnormal lows. Now, as
default rates rise, volatility will
pick up again and we will see more alpha.
Economic indicators did stabilise and
we are now seeing geographic decoupling.
Recently I am just beginning to see
evidence of individual equity cluster
volatility, as shown on the chart below.
This is possibly the signal I have been
waiting for to see improving equity
trading markets again. It certainly
will help statistical arbitrage and
so my next Sopa will focus on statistical
Cluster Volatility in
In section two I have shown how the market
has changed on the short side. Clearly the
opportunities have changed and those that
understand the opportunities are making
Short selling is a beta game for most of
the hedge fund industry now. Since few managers
claim to have any beta edge, we must ask
what we are paying for. As a fund of funds
that does make beta-driven adjustments to
our portfolio, it is time to use shorting
to get more neutral. We have also been careful
to look for alpha and we are finding it
though it is as rare as new copper mines
Good luck in your investing and we hope
you enjoyed your piranha soup
Sopa Piranha was originally
published by Wolf International, 31 October