Monday, June 29, 2009

The Temptation to Go Short

There appears to be general agreement that a bottom in the stock market indexes was achieved on or about March 9, 2009. April was a strong month, and in some cases showed the kind of progress one sees in what we used to think was a “normal" year. May, and the first few weeks in June, showed additional progress, but at a slower rate. The penultimate week in June showed some weakness. Now we have just two days to see whether we will have a trading rally for the late institutions trying to get rid of too much cash, and trading desks attempting to square their positions.

The popular press (if that term is meaningful anymore), is developing an expectation gap. Very few new jobs have been created by the government’s stimulus. Auto sales have not picked up since the intervention. Interest rates are low, which in many respects shows the lack of solid loan demand. Though somewhat counter-intuitive, many would consider moderately rising rates a plus.

Could we see another test of the recent lows? The answer is yes. But that is not the right question. The correct question is, “What are the odds that we have seen the bottom for most stocks in 2009?” My guess is that there is a better than a 75% chance that we have seen the bottom for most stocks. There is a new symbol for this bottom, “VL.” This suggests that we have already seen something of a “V” bottom coming off the March lows, to be followed by dull, relatively flat movements of most prices. (Within the horizontal portion of the “L” there is plenty of opportunity for trading successes.) Some believe this flat, range bound, market could last for a long time. One might say “VL” stands for very long.

In the face of these observations, why do I believe, in general, shorting it is now unwise for most investors? Often, the study of mutual funds provides answers to larger investment questions. The mutual fund industry is competitive always within its own market, but has grown by entering other providers’ markets; money market, tax exempts, and bank loans are just three examples. Many in the fund business feared the “retailization” of hedge funds (the decline of hedge fund minimum investment requirements) might cause mutual funds to lose customers. The counter attack by the fund industry was led by the so-called 130/30 funds. These funds invest 100% of their assets on the long side and with the use of leverage (often margin) allocate 30% on the short side. Other funds, also willing to bet on declines at least of the markets, if not civilizations, are available.

My old firm, once Lipper Analytical Services, now known as Lipper, Inc., created an investment classification called “Dedicated Short Bias Funds” as a peer group for the 130/30 and other funds betting, at least in part, on a decline. Setting up this peer group worked well. In 2008, and again in the first quarter of 2009, Dedicated Short Biased funds were the best performers (and often the only profitable funds on average) in the diversified US equity fund super-group. As I have often stated, fund performance is cyclical, driven by the highest mathematical power, within a large universe, of reversion to the mean. (Both the leaders and the laggards move in the direction of the middle of the array, often way beyond the point of becoming the new leader or laggard).

I doubt that there will be a meaningful reversal of the performance and rank of the average Dedicated Short Biased fund for the first half and second quarter of 2009. In both periods, these funds are the only classification within the U.S. Diversified Fund super group which shows negative results. Their current fund declines of over -20%, is larger than any other fund in the super group on the upside. (A number are getting close to a 20% gain for the first half.) Further, I believe it is too early to see a counter-reversal for the short sellers.

Thus my considered judgment for investors, not traders, is: this is not the time to go short.

No comments: